Chapter 1 ITRODUCTION TO MICROECONOMICS

WHY STUDY ECONOMICS

No simple definition of economics can fully explain all that

economists do. However, we can say that economist study how
the economy works and why- as evidenced by such problems as
poverty, unemployment, and inflation- it sometimes works poorly.
In fact, economics can be characterized by the question it seeks
to answer.

Economics is also a way of thinking. Economists

approach the study of real world problems from the standpoint of
certain basic economic principles. They assume that individuals
choose those options that best help them achieve their goals.
Economists also believe that a business seeks to maximize
profits and that it will produce more goods when it can earn
greater profits.

Economics may also be viewed as a collection of

concepts about and the perspectives on some of the problems
society faces. These concepts and perspectives are derived from
the economic way of thinking.

The reason why we need to study economics would be

practical because everyone makes economic decision everyday.
Since 1998, the economy continuously experiencing a decline,
consumers are facing diverse problem such as poverty, public
utilities and even rights and privilege are in questions, thus we
must continue to make a choice.

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 For the past twenty years, professionals where not
concerned about economics during their busy days. Doctors and
the like would just work and enjoy the fruits of their labor. Today,
people are getting to be more concerned about economics. The
current economic situation seems to interest not only
professionals but also ordinary civilians and most specially
students. Considering that these people have had no actual
background in Economics.

Students from all walks of life has a different perception

about economics specially during their high school days,
economics was thought with a simple household chores in their
school, nevertheless students taught the same when they enter
college. With the existing problem encountered by most of the
economics professors, the author decided to create a module
that would help students find out the importance of economics
and enjoying it during the whole term.

ECONOMICS – is a social science which is the proper

allocation of scarce resources to satisfy the unlimited human
needs and wants.

2 Branches of Economics

Macroeconomics – studies the aggregate level of

economic activity, such as the total level of output, the level of
national income, the total level of employment and the general
price level for the economy viewed as a whole. It deals with the
total private expenditure, total investment, total government
expenditures, and total imports and exports of goods and
services. It seeks the causes and the cures for unemployment,
inflation, and balance of payments.

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 Microeconomics – studies of economic behavior of
individual decision-making units such as consumers, resource
owners of business firms. It deals with how an individual
consumer spend his income to maximize satisfaction, how a
business firm combines resources or factors of production to
maximize profits and minimize cost and how price of each
commodity and each type of resources is determined by demand
and supply. It studies how these individual decisions are affected
by different forms of market organization.

Characteristics of Microeconomics

1. Microeconomics looks at the decision of individual

units. It focuses on the choices made by individual decision units
such us households, producers, and firms. Resource allocation
decisions are made by these individual entities in a market
economy. It is necessary to understand their decisions in order
to understand our economic system.

Among the relevant questions that can be asked are: how

efficiently are we using our resources? Could we obtain more
output from the same resources if we reorganize the ways we
use them?

2. Microeconomics looks at how prices are determined. It

is concerned with how prices are determined in various types of
market structures such as pure competition, monopoly,
monopolistic competition and oligopoly. Microeconomics is often
called,” price theory”.

Among the relevant questions that can be asked with

regards these characteristics: should a monopolist increase his
price? Should a producer in an oligopolistic market lower his
price? Can a producer under a purely competitive market
increase his price?

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 3. Microeconomics is concerned with social welfare. It
also examines the efficiency, relative desirability, and choice of
alternative methods by which resources are utilized to alleviate
scarcity. This branch of microeconomics is referred to as
“welfare economics”.

Among the relevant questions that can be asked are: is it

prudent to build a new bridge or to buy additional arms for the
army? Is it wise to impose price control? Should the government
limit the controlling interests in media?

4. Microeconomics has a limited focus. Microeconomics is

just a part of economics discipline. It does not examine the
processes or efficiency of allocation in alternative types of
economic systems, such as a socialistic planned economy.
Neither does microeconomics focus on other economic issues,
such as the aggregate level of employment of resources or the
rate of inflation. Problems dealing with the aggregate economy
are within the domain of macroeconomics.

5. Microeconomics develops skills. The study of

microeconomics helps to develop a set of useful and marketable
skills.

a. Microeconomics helps you develop your logical

reasoning.
b. Microeconomics will help you develop skill in the
construction and use of models. This is one of the
major skill economists offer to the business
community.
c. Microeconomics employs optimizing technique that is
useful for making decisions in a variety of situations.
d. The concepts studied in microeconomics are
applicable to your personal resource allocation
decisions, such as your carrier choices or financial
investments.

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Problem of Scarcity

Scarcity – the fundamental conflict between unlimited human

desires and limited availability of resources.

The problem of scarcity started as early 100 B.C. where

rulers and even the government administrators failed to predict
the continuous increase of human populations with limited
resources.

Needs Wants
1. Food To nourish life Expensive food
2. Shelter To nourish life Luxurious house
3.Cloth To nourish life Expensive Cloths
4. Transportation Expensive form of
transportation
5. Expensive mobile
Telecommunication phone
6. Entertainment Expensive form of
entertainment

Economic Resources

Before we can discuss what choices must be made, we

must establish the limitation within which our society must
operate. What is resources, how we identify resources, and
how do we, as member of society, develop these resources.

Resources are those inputs which are used in the

production of goods and services, for example, cars, TV sets,
machines, restaurant meals, etc. economist usually divide
resources into three categories: Land, Labor, and Capital.
This division, however, is simply for convenience; most
resources appear as combinations of land, labor, and capital.
Sometimes, even the services provided by government are
regarded as unique resources. Also, the skill called
entrepreneurship, the ability to operate a business and take
the risk involved, is cited as separated resources. Consider
each of these resources separately
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 LAND – Refers to all natural resources which are usable
in the productive process. This includes arable land, mineral
deposits, forests, and water resources. These resources are
“gifts” of nature and come fron natural features of our earth and
environment.

LABOR – Refers to all physical and mental efforts of a

man which can be used to produce goods and services such as
teacher, doctors, accountant, nurse, computer programmer,
mechanist and others. Labor receives wages or salaries

CAPITAL – Refers to all man-made aids to production.

This includes tools, machineries, equipment, buildings, and
transportation networks. The term “capital” being defined does
not refer to money which available for use in the purchase of
machinery, equipment, and other productive facilities. Because
money or financial capital is not considered capital in economic
terms. The factor payment for capital is interest income.

ENTREPRENEUR – Refers to a person or persons who

sets up a firm by combining and organizing properly the 3 basic
factors of production such as land, labor, and capital to supply
goods and services that he thinks society wants or needs. The
entrepreneur hopes to make profit – normal- profit which is the
amount that is left behind after all allocation to the other
economic resources have been made.

Production Possibilities

This concept illustrates the choices a society makes in

using its resources. To apply the concept of production
possibilities, we will consider a hypothetical economy and make
some assumptions or ground rules to describe it..

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Assumptions

1. The economy will always employ its productive resources

fully in the most efficient manner.
2. The supply of all resources is fixed in both quantity and
quality
3. Technology does not change during the period of time
being considered
4. The economy produces only two products. Steel and
coffee

Since resources are limited in supply, and if fully employed,

any increase in the production of steel will shift resources
away from the production of coffee. Or, if the production of
coffee is increased, steel production will decrease.
Resources can be made available only by shifting them from
one type of production to the other. Table 1 shows the
alternative production possibilities for this economy which
produces only steel and coffee.

Table 1
Production Possibilities of
Steel and coffee
Per month/per tons

Possibility Steel Coffee

(production
Alternatives)
A 16 0
B 15 1
C 13 2
D 10 3
E 6 4
F 0 5

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 Table 1 shows that six alternatives are possible. By
selecting alternative A, society can have 16 tons of steel but no
production of coffee. Alternative B indicates that if one less tons
of steel is built, one ton of coffee may be produced. Alternative E
shows that if six tons of steel are built, society can have four tons
of coffee.

Figure 1 is the graph of the data from table 1. it is called

production possibilities curves. If instead of using only six
alternatives, (A thru F), we showed all possible combinations, we
would have a series of points which make up Production
Possibilities Curve.
Figure 1

16 A
15 B
14
13 C
12
11
10 D
STEEL 9
8
7
6 E
5
4
3
2
1 F
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
COFFEE

The law of increasing Costs

In table 1 you may noted that as the number of steel

increases by one at each possibility, the number of coffee
decreases by an increasing amount . we can compute the
opportunity cost by following the given formula:

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 Opportunity cost = quantity2 - quantity1

Wherein:
Quantity 1 is the original product produced
Quantity 2 is the new product produced

Table 2

Possibility STEEL Opportunity COFFEE Opportunity

cost cost
A 16 0
B 15 1 1 1
C 13 2 2 1
D 10 3 3 1
E 6 4 4 1
F 0 6 5 1

A greater sacrifice of steel is necessary each time coffee

increase by one ( see table 2). The opportunity cost of the first
ton of coffee is one ton of steel. The opportunity cost of
increasing from one ton of coffee to two tons of steel . in other
words, the resources used for producing steels and coffee
cannot be traded on a one-for-one basis at all level of output.
They are not perfectly substitutable. Instead, the opportunity cost
in terms of steel increased more and more each time that one
ton of coffee was produced. This imperfect substitution of
resources reflects the Law of Increasing Costs.

The Law of Increasing Cost states that to obtain equal

additional amounts of one product, increasing amounts of
another product must be sacrificed.

Basic Economic Problem

1. What to produce - is a question of the types of goods

society desires. Will a third world country like Philippines
produce rice, copra, mangoes, bananas or will it be more
profitable to produce handicrafts products such as bags,

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 tables and chairs etc? Or if our country will focus on the
manufacture of industrial products. Since our resources are
scarce or limited, no economy can produce every product
desired by members of the society.

2. How much to produce – refers to the quantity of each good

that will have to compose the total output. Assuming
Philippines decided to manufacture bags, how many bags
should be manufactured? Or if rice production is decided on,
how much should the total output is?

3. How to produce - How to produce is a question on the

techniques of production and the manner of combining
resources to come up with the desired output. This basic
question makes entrepreneur unique, why? Because these
people or group of people should address problem of scarcity
such as, what materials should be used? Thus production
needs more labor or the use of more machinery? How will the
available resources be combined properly to come up with
the most efficient output.

4. For whom to produce – refers to the market wherein society

should concentrate to sell their products. In economics,
people are distinguishing the needs and wants of a human
being and how they can satisfy them, nevertheless, will a
particular product such as bags be sold in a high income
groups or to lower income buyers? Will the market be males,
females or children? Will the product be sold in local
consumers or to the international market?

Answering the needs of the society would be impossible

considering the factors of production is limited together with the
basic economic problems, it can deprecate economic problem by
determining the primary needs and how these goods and
services should be shared among the members of society. But
we cannot eliminate the existing economic problems.

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 Economic System – the institutions and mechanisms
used to determine what and how to produce and who will receive
the goods and services produced.

Common types of Economic System

CAPITALISM

Is an economic system where the control of enterprise is

in the hands of individuals and the private sectors. It is where the
ownership and use of the means of production as well as the
production and distribution of goods and services are determined
by the individual producers in the private sector.

Characteristics

1. Property ownership – it is the right to acquire, use

and dispose anything of value. The exercise of such
right is within the implementing laws of the
government.
2. Freedom of enterprise – freedom to enter and leave
any business venture. This freedom is governed by the
laws pertaining to business like factory laws, food and
drug laws and other public service laws regulating
these rights.
3. Competition – since anybody can enter into business,
more people will be producing the same product of
different brands. Due to the number of producers in an
industry, competition exists.
4. Profit motive – is the core of capitalism in the sense
that it is the main reason for the use of properties in
entering an industry where the producers compete for
profit.

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Evolution of Capitalism

Capitalism was already in existence in the ancient civilization of

Egypt, Babylonia, Carthage, Greece and Rome. This became
popular 1800 when Laissez Faire emerged after Feudalism and
Mercantilism. It further developed with the start of the industrial
revolution especially during the period 1776 -1840, since the
procedures of the old civilizations were changed.

In the 18th century, merchants had large amount of

money/capital and they were ready to invest in new products.
The steam engine paved the way for such investments.
Factories where set up in England and in other parts of Europe
and the United States. There was the change in the procedures
brought about by the new machinery. The industrial revolution
was then in progress.

In capitalism, the individuals are free to make their choice,

individuals are to generate income, how to spend their income
and choose the products and services that they want the
companies are also free to determine what product /services to
produce or render, how to allocate the resources, how to
produce and how much to distribute. They are also governed by
the law of supply and demand as well as the price system.
Capitalism is also known as free enterprise since the private
individuals are free to join economic organizations, though there
are other names given to capitalism: free market system,
entrepreneurial system and laissez faire.

Disadvantage of Capitalism

Society

1. Exploitation – the workers are exploited when they

receive low pay for the services rendered. The
capitalist derived more profits than the workers who
produce these products did.

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 2. The Inequalities – the workers are not treated fairly
since low wages are paid and less benefits are
enjoyed by them.

Economy

1. Surplus production – due to the desire for profit, the

tendency is to create scarcity of resources since more
resources are utilized for the production of more
products. This can lead to waste, since there are
already several firms producing the same product of
different brands.
2. Underemployment – this is the result of oversupply of
manpower on the same line of profession or trade.
3. Stiff Competition – it may exist among companies
producing the same product of different brands where
one company will try to destroy the other company just
to sin the support of the consumers.
4. Concentration of the economic resources in the
hands of the few – this may either result to monopoly
or the absence of competition or oligopoly or
competing among the few. This may result to
desperation of the management of the owners or some
limitations to the power of the owners.

Government

 This may result to resolving the priorities in terms of the

needs of the private sectors by the government

Countries where Capitalism is prevalent

 United States
It is a democratic country that practices free
enterprise where the people have the right to expand their
properties by entering into business.

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 Philippines
There is the freedom of an individual to enter any
business venture where one can maximize profit. This
may involve producing and selling of local or imported
products.

 Japan
Japan is investing its money in different countries
of the world in order to further gain control of the
economic activities globally. Other countries are Canada
and West Germany.

SOCIALISM

Socialism is the system of public ownership and control of

the major means of production while limited ownership and
control of small scale industries are left to private individuals but
still under the control of the government.
An economic system where there is public ownership of
the means of production and distribution are socially and
democratically managed for the common good.

History

Socialism began in 1830 in France and Great Britain. Its

idea was propagated by Robert Owen. The most popular of
socialist was Karl Marx, whose works/writings became the basis
of other socialist countries. In the 19 th century, under the
leadership of Nikolai Lenin, socialism gained ground in the
Soviet Union. Communism became distinct from socialism and
after the Second World War, Marxism became the socialist
ideology.

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 The term socialism was first used in the 1830’s. at the
time, the industrial revolution was in progress in Europe land the
U.S. two classes emerged: the capitalist who owned the
industries, and the laborers.

The new industrial system of the capitalist faced opposition from

various radicals.
One of these are the socialists, whose idea of socialism is
geared towards the establishment of a Utopian society that is
based in cooperation and not competition and this society will
work for the fulfillment of the needs of the people.

Characteristics

 Controlled private property

 Equal distribution of wealth
 Equal opportunity and benefits for all members
 Controlled production and distribution of the needs of the
people
 Provision of the opportunities for the satisfaction of the
needs and wants of the people
 The major means of production are owned and controlled by
the government while small scale industries are left to the
private sectors but still under the control of the government
 Economic decisions are planned by the central planning body
 It is the road towards the achievement of “full communism”

Advantage of Socialism

It will provide for social, intellectual, and economic reforms

that will lead to modernization and industrialization development.

Disadvantage of Socialism

Exploitation by socialism and poverty cannot be

overcome. But rather it will result to forced industrialization.
Individual ideology is used to cover up the political motive,
exploitation and economic knowledge.
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 The income that the people receive is not commensurate
for the effort exerted. It is because the people receive equal of
the same income.

Countries where Socialism were applied

Czechoslovakia Africa
France France.,
Yugoslavia Germany
North Korea England
Jamaica
Tunisia

COMMUNISM

This is an economic system that allows the complete

ownership, management and operation of all the means of
production and distribution of goods and services by the
government. They implement the doctrines of communism of the
Communist Party of the Soviet Union. It is a social system where
the properties are owned by the states and the wealth are
distributed to the people according to their needs. The
communist parties among industrialized societies will surely
embrace “full communism” though it will take several years.

History

The term communism is from a Latin word communis

means “common”. Communism believes that the state is more
important than its citizens. This idea came from Plato, a Greek
philosopher, who wrote the classical political treaties, The
Republic. Other writings supporting such an idea are Utopia by
Thomas More in 1516, and the Communist Manifesto written by
Karl Marx and Friedrich Engels, in 1848. These writings
influence the rise of communist parties in several countries.
The first communist state was Russia which became one
after the Bolshevik Revolution of 1917 under the leadership of
Nikolai Lenin. China, East Germany, Czechoslovakia and Cuba
also became communists after the World War 2.
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 One reason for this is the weakness of their government
especially after the Second World War another is the strength of
the USSR which enabled her to conquer states mostly Eastern
Europe. This contributed to the so-called “cold war” the end of
which was witnessed in the early 90’s with the breakdown of the
Berlin Wall.

While the original idea of communism was Plato’s

because of his belief in a society of common ownership, it is
actually Karl Marx who can be called the father of communism. It
was Marx who set down this system of belief as a response to
the poor condition of the working class. Marx thought that the
prevalence of communism would start in the capitalist countries.
Historical development proved him wrong. In 1917, Nikolai Lenin
and Leon Trotsky established this rule in Russia then an
agricultural-based state that was lagging behind in Europe’s
Progress.

It was here that for the first time, the theories of

communism were applied. And it was from here that communism
will spread its influence in other parts of the globe.

Characteristics

o There is a single party that governs the state

o All property is owned by the state
o The state controls and supervises all productive
activities
o Everyone is considered equal, no one enjoys
privileges based on the status in society
o There is equal distribution of goods and services
o The principle “from each according to his ability, to
each according to his needs” is applied
o There is no private ownership of property
o The economy is centrally planned
o There is the use of force

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Strengths of Communism

o Individual work for the benefit of the state

o The government runs the economy of the state
o Government choose a person’s work according to
capacity
o Absence of competition
o Work is according to ability, compensation is according
to needs
o Government dictates prices of goods and services
o Reward system for productive workers
o All resources/factors of production are nationalized
o A system of punishment for various offenses
o Absence of social classes

Negative Practices of Communism

o The use of violence, war, chaotic revolution or

insurrection as means to obtain power
o Dictatorship do not allow public criticism
o Use of totalitarian form government where there is
absolute control
o Absence of oppositionist candidates where the voters
have actually no choice during election
o The selected few government officials make decision
for the people
o The important position in education, government and
military are under the control of the communist party
o Absence of free enterprise
o Public ownership of land, banks, natural resources,
trade and industries, transportation and
communication.
o The government decides on economic problems that
must coincide with the policies of the communist party
o The people who give public criticism to the policies of
the communist party are prosecuted
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 o The people are not allowed to establish organizations
or newspapers that will criticize the party
o The practice of religion was discouraged since they
treated religion as a hostile force. Is because the
presence of religion may hinder them to use violence
in stopping unjust practice

Countries where Communism is applied

Soviet Union

All the economic organizations and processes are

under the laws of the government and the Communist Party of
the Soviet Union. The industries are managed by the ministries
of the government. It is under the administration of the
government that the republics, branches and operation of all
industries, agriculture, public utilities and trade are controlled

Red China

Communist China under Mao Tse Tung where the

government controls all the industries, agriculture trade. There is
equal distribution of wealth in a commune though quota was
imposed on the workers.

Yugoslavia

An economic system that is in line with communism

though it is a democratic centralized communist system where
the workers can partake in the operation of a socialized industry
and the farmers can own and cultivate their lands through
cooperative agriculture.

Other countries that practices communism:

1. Poland
2. Czechoslovakia
3. Hungary
4. Vietnam
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 5. Bulgaria

OTHER ECONOMIC SYSTEM

FEUDALISM

Feudalism is a system of relationship among the

members of the upper class of Medieval Europe whereby a
person is given a piece of land in exchange for military and
political services rendered.
In a broader sense, feudalism denotes “feudal society”
which is a form of civilization and a type of society with certain
characteristics besides the mere presence of the Lords, vassals
and fiefs. The people of the era performed civil or military service
in exchange for land to be tilled. “Vassals” belongs to the
warriors class of the period who is the recipient of the land
known as fief of feudum, while the feudal Lord is the head of the
manor. “Manors” are the agricultural states the were formed after
the division of the empire due to its fall.
Thus, feudalism was derived from the word feudum
denotes that it’s the system of landlordism. It was originally done
simply to establish a mutually protective relationship. The period
was characterized by a chaotic social condition, thus, there was
a need for the establishment of strong military organizations
through the use of the land or fief. Therefore, it is more of a
military or political organization than an economic system
The Lord and the vassals were interlocked in the web of
mutual rights and obligations in a well-protected castle. It
undertook any initiative of importance to the feudal community as
a whole.

History

Feudalism may have the beginning in the chaotic times

that characterized the Dark Age when Barbarians where in
control after Alaric. The leader of the Visigoths captured Rome
and much later on when the Roman Empire finally fell in 476
B.C.

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 The Dark Ages was followed by the Medieval Period or
the Middle Ages where manors came into being.
Feudalism reached its height in the middle of the 11 th
century up to the 13th century.

Vassals Obligations to the Feudal Lord

1. he must render military service at the time when it

is needed
2. he is responsible for planning all the activities of
manor
3. Financial obligation at the time when it is needed
by the Lord like marriage of the lord’s daughter,
part of the ransom’s money when the lord was
kidnapped, or anytime the manor needs some
financial contributions.

Causes of the decline of Feudalism

o land became so significant and a wide spread of

money in towns and cities
o spread of capitalism and gunpowder

Feudalism was eradicated in England in 1622 but it has a

tremendous influence on the Revolution of 1789 that put
an end to the practice of feudalism in Europe although
Germany had a hard time in eradicating feudalistic
practices.

Countries under Feudalism

The Kingdom of Franks was the first site of feudalistic

system. Such kingdom was between two rivers, namely
Rhine and Loire Rivers. The Carolingian Empire, which
was composed of the following: southern France,
Catalonia, Conburdy, Saxony and Bavaria, was under the
feudal system too. It also reached Great Britain, Southern
Italy, Jerusalem and the Latin Empire of Constantinople.

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 The Slavic and Scandinavian states were also
influenced by the feudal system of Germany.

CACIQUISM

Is the system of landlordism in the Philippines during the

colonial period of the Spaniards. The rich landlords were called
the caciques while the farmer who used the lands were called
the tenants or kasama.
It is a political, social and economic system where the
local administration was managed by the cacique. It is a type of
bossism, semi feudalistic and property ownership.

History

It is the counterpart of the feudalism in the Philippines

reckoned by the Filipinos who had a chance to occupy a position
during the Spanish period. The caciques were the influential
citizens occupying higher positions in the society during the
colonial period. It is described the rural way of life during the
Spanish times. Such practice was already widespread even
before the coming of the Spaniards. This was the
implementation of taxation.

The caciques were similar to the feudal barons of

medieval Europe during the rise of the feudalism. He is
powerful, wealthy and occupies a high status in the society. He
has control over other citizens of his town. As a patriarch he is
responsible for the economic, social and spiritual well- being of
the people, as a “father” to everyone, he is being respected and
served by the people. They were the tax collectors, in charge
with the safety and justice of people within his jurisdiction. He
served as a mediator between the religious groups and the
government officials of Spain during the period.

SYSTEM OF LAND ARRANGEMENTS

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 Inquilino system- it is also known as the “leasing system”
since rents are paid to the cacique for the use of the land.
The cacique is an absentee landlord where he need not have
direct supervision over the piece of land being loaned since
his interest lies on the rents which are paid in cash or crop
equivalent (kind).

 Kasama system- it is the system of partnership where the

tenant and the cacique contributed to the cultivation of the
land then produce will be divided equally.

If the labor plus all the materials and expenses are

shouldered by the tenant while the cacique contributed only
his land 2/3 the harvest will go to the tenants while the
remaining 1/3 will be received by the cacique.

On the other hand, if 50% of the expenses and materials plus

the labor is shared by the tenant or kasama, while another
50% of the expenses and materials will be shouldered by the
cacique plus is land, then the harvest will be divided equally.

 Tenant-servant System - The tenant enjoyed free board

and lodging in the sense that he was given a small house and
lot near the vast land known as hacienda that he will
cultivate. As a servant, his duty is to cultivate the land. In
return he will receive a fixed share from the harvest whether
he has good or low harvest.

 Clearing system – This system applies to “virgin lands” that

require some clearing. During the process of clearing, no
rents are paid to the cacique. But after the clearing, less than
50% of the harvest goes to the cacique and as the harvest
improved, 50% or more is imposed.

EVILS OF CACIQUISM

 Usury System – It is the practice of lending money that

prescribed a very high rate of interest like the following:

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 a. Takipan – It prescribed 100% rate of interest
per harvest.
b. Talindua – It prescribed 50% rate of interest
per harvest.
c. Terciahan – It prescribed 33-1/3% interest per
harvest.

 Paternalism - It refers to the complete dependence from

the lord where he was seen as a great provider of
everything. Due to such practice, it resulted to the
laziness among the Filipinos who can no longer decide on
their own and cannot stand on their own feet.

 Asking for Free services – Because of the utang na loob

or debt of gratitude, the money borrowed are not only paid
in cash but even in services.

 Curtailment of the Right of Suffrage – It is not only the

land and its harvest that is being controlled by the cacique
but even his mind specifically his choice of candidates.
The cacique will dictate to his tenants whom to vote for
and failure to follow will mean that their lives will be
threatened.

DECLINE OF CACIQUISM

Caciquism lasted in the Philippines for several years

during the Spanish Period since the tenants were very obedient
to their cacique. But with the coming of the Americans who
introduced education, caciquism slowly declined. This is because
education was the strongest force to fight caciquism. It was due
to education where people became aware of the quality of all
men regardless of his race, religion or color. The inferior feeling
of being brown or black and the wrong notion about Catholicism
were totally eradicated due to education. Thus, people started to
fight for their rights.

24
MERCANTILISM

Mercantilism is a political theory that was widely accepted

in Europe in the 16th to 18th centuries. If the state is to gain
wealth, power and prestige, the government was control the
economy.
This is based on the mercantilist doctrine which states
that the wealth of a nation is measured by the amount of gold
and silver it has accumulated through export of its products as
well as conquest of small states.
This was aptly called nationalism through commerce.

History and Nations who practice Mercantilism

Mercantilism was widespread in Europe from the16th to

18th centuries. It was used in Great Britain, France, and the
Netherlands in the States that they conquer such as New
England, the Caribbean countries, and the west Indies. This was
practiced too, by Portugal and Spain in their conquest of the
Philippines. This system prevailed in America when it came
under the control of Great Britain, France, Spain and Portugal.
Up to this time, countries in the so-called New World show
manifestations of their colonial past under these countries, such
as language, laws, religion and beliefs.
Today, however, the system of mercantilism no longer
exists

Economic activities emphasized under Mercantilism

 Precious metals like gold and silver were used as

the measure of the wealth of nations.
 If a country has no mines or access on them, then
gold and silver should be obtained by means of
trade.
 Favorable Balance of Trade must be maintained
where exports are greater than its imports.

25
  Each country wishes to have a large population for
it will provide for a supply of labor, big market and
source of soldiers.
 Consumption of imported luxury goods are
discouraged for it will bring out the country’s
precious metals.
 Manufacturing are forbidden in the colonies since
they will be the market of their mother country.
 Thrift, saving and patrimony were regarded as
virtues.

When mercantilism was eradicated, it gave way to a new

economic
system known as capitalism.

FASCISM

A rightist political movement which governed Italy as

dictatorship from 1922-1943. Fascism was derived from the Latin
word fascis, or bundle of rods to symbolize authority and power.
It is an economic system where the dictator controls all the
industries.
The founder of the fascist movement was Benito
Mussolini and his followers at Milan, Italy in March 1919. He was
an Italian dictator from 1922-1943. It emerged in time and
proclaimed as the enemy of Italian communism. The fascism
promised reforms through violence.
In Germany, Fascist Party of the National Socialist
German Workers’ Party of the Nazi Party was headed by Adolf
Hitler. Hitler disregarded the use of the constitution in Germany
and transformed the country into a fascist state. He was
remembered for murdering millions of Jews to prove the
superiority of the German race.

26
 Characteristics

 The rule of totalitarianism or dictatorship.

 Complete control and management by the
government of all the political, economic, social,
cultural and religious affairs of the nation.
 Some industries were allowed to be privatized
provided they are still under then control of the
government.
 Patriotism and war-like policies were imposed
 All industries are strictly managed by the
government in order to make sure that the needs of
the country are met.
 Importation of products from other countries are
prohibited
 Strike and organizing trade unions are not allowed
by the government
 The corporation established by the government are
run by government workers and employees.
 Government fixed the wages, working hour and the
production goals of corporation.
 The government controls the newspaper, radio and
other means of communication.
 Any violation to the rules of the government may
result to punishment, imprisonment or death of the
violator.
 The young are encouraged by the government to
join the organizations that are promoting the
teaching of fascism
 The national planning board plans the economy.

Advantage of Fascism

a. Emphasis is centered on the economy.

b. Workers enjoy equal wages and benefits.
c. Discipline is inculcated among the people starting from
their childhood days.

27
 d. Production is focused of the needs of the country
e. The country does not depend upon the importation for
goods from other countries
f. Production is not delayed by strikes
g. Limited private ownership is allowed

Disadvantage

a. The rights and freedom of the people are limited by the

government
b. Violent and war-like policies are implemented by the
government
c. Presence of only one political party
d. Absence of the freedom of speech and press
e. Violent means are used to achieve their goals
f. There is no respect for private life of the people
g. Spiraling of prices of the products
h. The minorities are exploited and killed in the process
of achieving their goals
i. The secret police are in charge of the opposition

Countries that implemented Fascism

Italy – Benito Mussolini started fascism in Italy; Germany

– Adolf Hitler was the leader who established the fascist state in
Germany; Hungary – the Arrow Cross fascist party led by
fascism in the 1930’s’; Romania – the Iron Guard fascist political
party was the strongest party in Romania; Japan – in 1930, the
fascist group became famous in Japan; Argentina – dictatorship
under the leadership of President Juan D. Peron was established
in Argentina from 1944-1955; Spain- during the Spanish civil war
(1936-1939), the France Espanola” a fascist group, supported
the revolution headed by Francisco Franco when he won as he
managed a fascist type of government in Spain.

28
Circular flow of Economic Activity

In order to understand how simple market economy

works, you must understand something about its two elements –
households and businesses-and how they interact. We refer to
household and businesses in economic sense. No doubt you are
familiar with the operation of at least one household, your own,
though you may not think of it as an economic unit. When
economists look at a household, they focus on its economic
rather than its social activities. For this reason, the household in
economic analysis is not necessary the same as a family group.
It is defined as any person or group of people living together and
functioning as a single economic unit.
Every society faces the fundamental problem of
scarcity-unlimited wants but limited resources-and the
fundamental question of how best to use those resources. This
question is not easy to answer because each individuals has
different wants and each resources has different uses.*

Economic Resources

Household Firm

Goods / Services

Savings BANK Loans

Taxes GOV’T Taxes

FOREIGN
Imported Export
COUNTRIES

29
30
Name: ________________________ Date:__________

Section : __________________ Rating:_________

Exercise No. 1.1

MULTIPLE CHOICE QUESTIONS

These questions are organized by topic from the chapter outline.

Choose the best answer from the options available.

A. Introduction

1.Economics is concerned primarily with:

a. money
b. determining corporate profits and losses.
c. The allocation of scarce resources.
d. Balancing your checkbook.
e. All of the above.

2. The fundamental questions of economic organization are:

a. closely related to the concept of scarcity.

b. Not nearly as important today as they were at the
dawn of civilization.
c. What, how, why, and for whom
d. Land, labor, and capital.
e. All of the above.

3. The economic problem of what goods to produce:

a. may be a problem for any individual firm seeking to make

a profit but is not in ay sense a problem for society as a
whole.
b. Can be illustrated as the problem of choosing a point on
the production-possibility curve.
c. Arises only when the stock of productive resources is
very small.
31
 d. Arises only when all productive inputs are so specialized
that each can be used only in the production of one good
and no other.
e. None of the above.

4. Capital is:

a. the same as money.

b. The headquarters of economic planning.
c. Both an input and an output.
d. All of the above.
e. None of the above.

5. Land, labor, and capital are:

a. available only in finite amounts.

b. Used to produce outputs.
c. The primary factors of production.
d. Combined with technology in the production process.
e. All of the above.

6. Scarcity is:

a. allocation of scarce resources.

b. Fundamental conflict between unlimited human wants with
limited resources
c. Both an input and an output.
d. All of the above.
e. None of the above.

7. Entrepreneur is:

a. Refers to natural resources which are usable in the

productive process
b. Used to produce outputs.
c. The primary factors of production.
d. Persons who sets up a firm by combining and organizing
properly the basic factors of production.
e. All of the above.
32
8. Economic system is:

a. refers to a quantity to each good that will have to

compose the total output.
b. market wherein society should concentrate to sell their
products
c. the institutions and mechanism used to determine what
and how to produce and who will receive the goods and
services .
d. all of the above

9. microeconomics

a. studies the aggregate level of economic activity, such as

the total level of output , level of national income.
b. Fundamental conflict between unlimited human wants with
limited resources
c. Both an input and an output.
d. studies of economic behavior of individual decision-
making units such as consumers, resource owners of
business firm.
e. all of the above

10. what to produce

a. studies the aggregate level of economic activity, such as

the total level of output , level of national income.
b. Fundamental conflict between unlimited human wants with
limited resources
c. is a question of the types of goods society desires.
d. studies of economic behavior of individual decision-
making units such as consumers, resource owners of
business firm.
e. all of the above

33
11. Land

a. allocation of scarce resources.

b. refers to natural resources which are usable in the
productive process
c. Both an input and an output.
d. All of the above.
f. None of the above.

12. Economics

a. proper allocation of scarce resources

b. Used to produce outputs.
c.The primary factors of production.
d. Persons who sets up a firm by combining and organizing
properly the basic factors of production.
e. All of the above.

13. How to produce:

a. refers to a quantity to each good that will have to

compose the total output.
b. market wherein society should concentrate to sell their
products
c. the institutions and mechanism used to determine what
and how to produce and who will receive the goods and
services.
d. a question in the techniques of production and the manner
of combining resources to come up with the desire output.

14. macroeconomics

a. studies the aggregate level of economic factitively, such

as the total level of output, level of national income.
b. Fundamental conflict between unlimited human wants with
limited resources
c. Both an input and an output.

34
d. studies of economic behavior of individual decision-
making units such as consumers, resource owners of
business firm.
e. all of the above

35
36
Name: ________________________ Date : ________

Section : __________________ Rating: _______

Exercise No. 1.2

MATCHING TYPE ( Write the letter beside the number )

a. Socialism 1. Economic
system that allows
complete
ownership,
management and
operation of all the
means of
production and
distribution
b. For whom to produce 2. question on the
techniques of
production and the
manner of
combining
resources to come
up with desire
output.
c. Capitalism 3 refers to all
natural resources
which are usable in
the productive
process
d. Microeconomics 4. a system of
relationship among
the members of the
upper class of
Medieval Europe
whereby a person
is given a piece of
land in exchange
37
 for military and
political services
rendered
e. Caciquism 5. refers to the
market wherein
society should
concentrate to sell
their products.
f. What to produce 6. derived from the
latin word “fascis”,
or bundle of rods to
power.
g. Entrepreneur 7. economic
system where the
control of
enterprise is in the
hands of
individuals and the
private sector.
h. Land 8. is the system of
public ownership
and control of
small scale
industries are left
to private to
individuals.
i. Communism 9studies of
economic behavior
or individual
decision-making
units such as
consumers,
resource owners of
business firms,.
j. Macroeconomics 10. economics is a
social science
which is
concerned the
proper allocation
38
 of scarce
resources to
satisfy the
unlimited human
needs and wants.
k. How to produce 11. studies the
aggregate level of
economic activity,
such as the total
level of the output,
the level of
national income,
the total level of
employment and
the general price
level for the
economy viewed
as a whole.
l. Feudalism 12. Refers to all
man-made aids to
production.
m. Capital 13. question of the
types of goods
society desires
n. Economics 14. a system of
landlordism in the
Philippines during
the colonial period
of the Spaniards
o. Fascism 15. Refers to a
person who sets
up a firm by
combining and
organizing
properly the 3
basic factors of
production.

39
40
Name: ________________ Date : ________________

Section : ______________ Rating : _______________

Exercise No. 1.3

IDENTIFICATION (Put the economic system on each given

Number )

Choices
a. Capitalism d. Fascism
b. Socialism e. Caciquism
c. Communism f. Feudalism
g. Mercantilism

___________________1. Stiff competition exist among

companies producing the same
product of different brands.
___________________2. Must render Military services at the
time when it is needed.
___________________3. The rule of totalitarian or dictatorship
___________________4. Consumption of imported luxury
goods are discouraged for it will bring
out the country’s precious metal.
41
___________________5. Everyone is considered equal; no one
enjoys privileges based on the status
in society.
___________________6. Freedom to enter and leave any
business venture. This freedom is
governed by the laws pertaining to
business like factory laws, food and
drug laws and other public service
laws.
___________________7. The principle “from each according to
his ability, to each according to his
needs” is applied.
___________________8. Tenant-servant system – the tenant
enjoyed free board and lodging in the
sense that he was given a small
house and lot near the vast land
known as hacienda that he will
cultivate.
___________________9. complete control and management by
the government of all the political,
economic, social, cultural land
religious affairs of the nation.
___________________10. Profit Motive is the core in the
sense that it is main reasons for the
use of properties in entering an
industry where the producers
compete for profit.
___________________11 the major means of production are
owned and controlled by the
government while small scale
industries are left to the private
sectors but still under the control of
the government.
___________________12 all property is owned by the state.
___________________13 the Lord and the vassals were
interlocked in the web of mutual rights
and obligations in a well-protected
castle.

42
___________________14 Cleaing system- this system applies
to “virgin lands” that require some
clearing. During the clearing process,
no rents are apllied to the cacique
___________________15 Any violation to the rules of the
government may result to
punishment, imprisonment or death of
the violator.
___________________16 there is a single party that governs
the state.
___________________17 Economic decision are planned by
the central planning body
___________________18 Competition – since anybody can
enter into business, more people will
be producing the same product of
different brands. Due to the number
of producers in an industry,
competition exist.
___________________19 Strike and organizing trade union are
not allowed by the government
___________________20 Provision of the opportunities for the
satisfaction of the needs and wants of
the people.
___________________21.There is the use of force
___________________22. Financial obligation at the time when
it is needed by the Lord like marriage
of the Lord’s daughter, part of the
ransom’s money when the lord was
kidnapped, or anytime the manor
needs some financial contributions.
___________________23 Government fixed the wages, working
hours and the production goals of the
corporation.
___________________24.It is the right to acquire, use and
dispose anything of value. The
exercise of such right is within the
implementing laws of the
government.

43
___________________25. Equal opportunity and benefits for
all member

44
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 1.4

Review Question

1. What is the differentiation between

Microeconomics and Macroeconomics

2. The importance of Economics to the society,

government and producers of goods and
services.

45
3. Why do we consider entrepreneur as important
economic resources?

46
Chapter 2 INTRODUCTION TO MICROECONOMICS

DEMAND AND SUPPLY

Because we live in a world of scarcity; we must choose

among alternative uses of scarce resources. We must decide
how best to use our own resources to meet our individual goals.
You are the decision maker directly when you buy goods and
services and sell your skills. You also make decision indirectly
when you vote for your mayor or congressman base on their
proposal. The chief characteristic of our economic system is that
it is market oriented. This means that many of the decisions
pertaining to what is produced, how things are produced, who
does what, and who receives what are made in a decentralized
fashion by million of people like yourself.

In a market-oriented economic system, price is the key

mechanism in determining the answer to the question above. To
understand this important concept of price, you must understand
demand and supply.

47
Concept of Demand:

A. Demand is defined as the purchasing behavior of people

when they are confronted with different prices for a specific
good or service during a given period of time. Demand
always implies willingness and ability to sacrifice something,
money or other commodities, in order to obtain a specific
good or service.

B. A Demand Schedule is a table that shows the quantity of

good or service that is demanded at each different price level
during some specified period of time. Quantity demanded is
the amount people are both willing and able to buy at a given
price. As can be seen in Table 1, there is a unique quantity
demanded corresponding to each given price.

Table 1
Demand for Fish During July

Price per kilo Quantity Demanded (Kilo)

75.00 10
65.00 20
60.00 30
55.00 40
50.00 50

C. The demand90 curve is derived by plotting the points from the

demand 80 schedule and joining them. The resulting line is
called the demand curve.
The price70 is placed on the vertical axis and the quantity
demanded 60 on the horizontal axis. See figure 1 in which the
data from50Table 1 are plotted.
PRICE
Figure 1
40

30

20

10
48
10 20 30 40 50 60

QUANTITY
D. The Law of Demand

The Law of Demand expresses the relationship between

price and the quantity demanded.

The Law of Demand assumes that all other factors, e.g.,

income, tastes and preferences, utility, prices of substitute
and complementary goods and future expectations, are held
constant (ceteris paribus). Each of these factors will be
explained shortly.

As you can see from the graph, the demand curve slopes
downward and to the right.

The relationship between price and quantity is called an

inverse relationship—as price becomes higher, the quantity
demanded becomes smaller.

There are two basic reasons for the Law of Demand:

a. At the higher prices other goods will used as
substitutes and potential buyers are lost. This is
called substitution effect.
b. When the price increase, it now takes more income
to buy the same quantity of the good as before the
price rise. This involves a loss of real income
49
 (purchasing power). Less of all goods will be
brought because of this income loss. This is called
the income effect.

Now that you have read about the law of demand and the
reasons for it., consider the following examples which illustrate
what underlies the Law of Demand.

Ella : Say Ellen, there is a great sale at SM Shoemart

today. The price of pants is marked down 50%; in fact, I bought
two pairs!

Ellen : I usually don’t wear pants, but at those prices I think

I’ll buy a pair.

The lower prices coaxed extra purchases from Ella and

brought in Ellen as a new buyer. Here is another example.

Ella : Japanese food is so expensive this week. I’m going

to buy hamburger instead.

Ellen : I’ll have to stay with a noodle for this week’s menu.
I certainly am tired of noodles, but they’re even cheaper than
hamburger.

Ella is going to substitute hamburger for ground chuck this

week. Ellen hasn’t been able to buy hamburger for a long time
even though she would like to buy it. Therefore, at the higher
price a potential buyer is lost because both purchasing power is
reduced and other goods are used as substitutes.

E. The market demand for a good is the sum of all individuals

demand schedules for that good. Table 3 shows how the
market demand is calculated. Figure 2 shows how it is
plotted.

50
 Table 3
The Method of Obtaining the
Market Demand for Banana in August

Quantity Quantity Quantity Market

Price per demanded demanded demanded Quantity
unit buyer 1 buyer 2 buyer 3 Demanded
1.25 1 + 0 + 0 = 1
1.00 2 + 1 + 1 = 4
.75 3 + 2 + 2 = 7
.50 4 + 3 + 3 = 10

In Table 3, notice that the quantity demanded for Banana

when its price is P1.25 is 1 piece for buyer 1, 0 for buyer 2. And 0
for buyer 3. Adding these up gives a total quantity demanded or
market demand of 1 at P1.25 per piece. At P1.00 per piece, buyer 1
demands 2, buyer 2 demands 1 and buyer 3 demands 1. This gives
a total quantity demanded or market demand of 4 pieces of Banana
at P1.00. The market demand at .75c and .50c is derive the same
way.

In Figure 2, the demand schedule of each buyer is plotted using

each demand schedule. The market demand curve is plotted using
the schedule of the total quantity demanded.

Figure 2

Buyer 1 Buyer 2 Buyer 3

1.50 1.50 1.50

1.25 1.25 1.25
1.00 1.00 1.00
0.75 0.75 0.75
0.50 0.50 0.50
0.25 0.25 0.25

1 2 3 4 1 2 3 4 1 2 3 4

Market Demand Curve

51
 1.50
1.25
1.00
0.75
0.50
0.25

1 2 3 4 5 6 7 8 9 10 11 12

F. The factors underlying demand are the following:

Income
Utility
Price of Substitute Goods
Price of Complementary Goods
Future Expectation
Taste and preferences

A very important factor underlying demand is INCOME. At every

possible price, people with a low income demand fewer goods and
fewer units of most goods than they would with a larger income.
Additional income allows a person to buy more and different kinds of
goods. An increase in income means a greater ability and
willingness to pay for a good.

Have you heard anything resembling the following

conversations lately?

“I got a raise today. I’m going out to buy that stereo cassette
that I’ve always wanted.”
“I just lost my job; I won’t be able to buy that stereo cassette I
wanted this year.”

52
 Therefore, an increase in income causes the demand for most
goods increase, and a decrease in income causes the demand for
most goods to decline.

The second factor underlying demand is UTILITY. People’s

demand for any good at any time will depend on the number of units
of that good they already own. Before buying an additional unit of
any good, a person normally considers what would be the utility or
usefulness of another unit of a good. One unit maybe very useful. A
second unit may be less useful. For instance, a car may be of great
use to me. A second car, however, is of much less use you can’t
use two cars at the same time. Therefore, the greater the utility or
the usefulness of a good, the greater will be the demand, and vice
versa.

The third factor underlying demand is the PRICE OF

SUBSTITUTE GOODS. Goods are considered substitute when they
provide almost the same kind in degree of utility or usefulness.
Buyers choose among substitutes guided mainly by price. What are
some examples of substitutes? margarine is a substitute for butter,
tea is a substitute for coffee. If a price of a good increases, the
demand for its substitute is very likely to increase.

The forth factor underlying demand is the PRICE OF

COMPLEMENTARY GOODS. Goods are considered
complementary when they go together or can be use together.
Buyers will increase their purchase of certain goods when their
compliments fall in price. Examples of complementary goods are
Bacon and eggs, automobiles and gasoline, lettuce and salad
dressing. If the price of lettuce rises, for example, less salad
dressing will be purchased. Therefore, if two goods are
compliments, if the price of one rises the demand for the other will
decrease.

The fifth factor is FUTURE EXPECTATIONS. People

anticipate what will happen at a certain time in the future. Buyers
may consider the following before they make a major purchase. Will
I loose my job? Will prices increase or decrease? Will there be a
surplus or shortage of this good in the near future? All these factor
53
influence whether people will make a purchase now and how much
they are willing to pay. Therefore, if the price of the good is expected
to rise, the demand for it will increase because people hope to
purchase the item before the price goes up.

The sixth factor underlying demand is TASTE AND

PREFERENCES or personal preference for something. You may
prefer one color to another. Or, you may like to wear sandals
instead of shoes, or prefer modern furniture, to traditional furniture.
All these reflect taste. The term taste is a catch-all which reflects
changes in preferences.

A change of any of these six factors can cause a change in the

demand schedule and, therefore, cause a shift in the demand curve.

G. A change in demand occurs when the entire demand

schedule changes graphically; if any of the determinants of
demand change, demand and the demand curve will shift.

Figure 3

An increase in demand for Banana

D2
3.50

3.00
D1
2.50

2.00

1.50

1.00

0.50

1 2 3 4 5 6 7 8
figure 3 shows that the demand curve for banana has
shifted to the right from original demand to new demand curve.

Figure 4

54
 A decrease in demand for Banana
3.50

3.00
D1
2.50
D2
2.00

1.50

1.00

0.50

1 2 3 4 5 6 7 8

figure 4 shows that the demand curve for banana has

shifted to the left from original demand to new demand curve.

Introductory Comments

In order to begin our discussion of supply, let us pretend

that you are a producer of a good or services. We will often
refer to a good or service as a commodity. Question which will
concern you are: how much will you produce, at what price will
you charge, how will you react if the price of your commodity
increases or decreases, and how will other producers react?

More specially , how will you, as the producer of

commodity, be affected if:

 The price of raw materials increases?

 The cost of labor increase?
 The interest rate rises?
 The weather is bad

The Concept of Supply

A. Supply is defined as:

The behavior or suppliers in terms of the quantity of a

commodity they are willing to sell when confronted with

55
 different prices for that commodity during some specified time
period.

B. A Supply Schedule

A supply schedule is a table showing the quantity of any

given product that producers are willing and able to offer for
sale at each possible price during some specified time period.
Table 1 is an example of a supply schedule. For each price
there is a unique quantity supplied.

Table 1

An individual producer’s supply schedule for the

production of Banana during July

Price per piece Quantity supplied

per week

.50 1000
.75 2000
1.00 3000
1.25 4000
1.50 5000

C. The Supply Curve

The data from the supply schedule may be plotted and a

curve drawn to connect each point. This curve is called the
supply curve. (see figure 1)

The price is placed on the vertical axis and the quantity supplied
on the horizontal axis.
56
 Figure 1
Price
2.00

1.75
S
1.50

1.25

1.00

0.75

0.50

1000 2000 3000 4000 5000 Quantity

D. The Relationship between Price and Quantity Supplied

The supply curve shows that as the price of any commodity

rises, the quantity that suppliers are willing and able to offer
for sale increases, assuming that all other factors that
determine supply remain the same. If the price of the
commodity falls, a smaller quantity of the good will be
supplied.

This is called a direct relationship: one factor increases as

another increases or one factor decreases as another
decreases.

a. The reasons for this direct relationship are:

As the price rises:

- The number of producers may increase.

- Each individual producer may supply more.

As the price falls:

- The number of producers may decrease.

- Each individual producer will supply less
57
Consider the following example of what may happen when the
price of a commodity rises.

Farmer 1: Hey Mike, the price of corn has gone up P10.00

a bushel. Looks like it’ll continue to increase, too.

Farmer 2: I know, Joe. I just heard it on the commodities

report on the radio. I’m not going to plant wheat this spring when
I can do better in corn.

Farmer 1: I wasn’t going to use all my acres for planting.

But now I’m going to plant all 200 acres in corn.

Here the increased price of corn persuaded Mike to plant

corn instead of wheat and Joe to use more of his land for
planting corn. Now consider an example of what happens when
prices fall….

Calculator Manufacturer ( Tom ) : Say Jim, do you see

how calculator prices are declining? I can’t make it at
manufacturing calculators anymore. My costs are just too high
given the current prices.

Other Calculator Manufacturer ( Jim ) : I sympathize with

you, Tom. I won’t have to go out of business yet, but I will have
to trim costs and cut back production.

In this situation, Tom will stop manufacturing calculators

and he will be out of the market. Jim will continue in the market,
but he will supply less than he did before the price decline.

When the prices rise, increase in production occur; that

is, suppliers are willing and able to supply more. To increase
this production, existing facilities are used more intensively,
overtime wages are paid, and equipment is frequently used more
intensively. When prices fall, the opposite occurs.
58
E. Market Supply

If market supply were similar to market demand, you would

expect it to be the sum of the individual supply schedules. But it
is not exactly that for the following reason. Competition among
producers will cause the price of resources or raw materials to
rise. This rise would not be so abrupt if a producer were in the
market alone. Therefore, because of these higher costs,
producers together will not produce as much in total as they
would with no competitors.

Consider the following situation which illustrates the

competition for resources.

Boss: The price of tape recorders has gone up in the past two
months. I would like to manufacture 30,000 more tape recorders
this month. But now everybody in this business is increasing his
production. They all have driven the price of plastic casing sky
high. I can’t buy as many casings as I need at those prices, so I
will only be able to manufacture 20,000 additional tape
recorders.

Let us now consider the factors underlying supply. They

are listed below.

F. The Factors Underlying Supply / Determinants of supply

Costs of production
Price of Goods
Availability of Resources
Technology
Number of Producers
Taxes
Weather
Subsidies

59
The first factor underlying supply is the cost of production. One
of the important costs of production is the cost of labor. How
much producers have to pay for help influences how much they
can produce or cheaply they can sell their commodity or even
where they will locate their plant. For example, in the last 30
years, manufacturers of sheets and pillow cases have moved
from the North to the South, mainly because labor costs are
lower in the South.

The cost of raw materials is very important. Raw materials

are land, water, and any other ingredients that make up the
commodity. If the cost of raw materials rises, the supply of the
finished product will probably decrease.

The interest rate-the cost of financial capital is another

cost of production. If the interest rate is high, producers will have
to charge more for their product. If the interest rate is low,
producers can charge a lower price for their product.

The second factor underlying supply is the price of

goods. A related good may be a substitute or a complement for
a product. Butter and margarine for example, are substitutes. If
the price of the butter rises, consumers will purchase more
margarine and less butter. The reverse would happen if the price
of butter falls. In either case, the supply of both butter and
margarine will be affected in opposite ways since they are
substitute goods.

The third factor underlying supply is the availability of

resources. The supply of goods in the market depends on the
availability of resources. More economic resources that offers
production means more supply of goods in the market.

The fourth factor underlying supply is the technology.

Improvements in technology make possible the production of
goods and services at lower costs. When these are adapted by
firms, they will be able to produce more.

60
 More players in the market create competition within, the
producers consider stiff competition as challenge to capture the
market. The fifth factor underlying supply is the number of
producers or sellers in the market. For the past 10 years,
Jollibee and Mc Donald is competing to capture the biggest
share in the food chain industry, with this competition, other food
companies such as Wendy’s, burger king and others help the
industry to supply more and consumers will take advantage of
promotions given by the said company to choose who among
them sells cheaper value meal.

Payment for taxes is an added component of the cost of

production. Therefore the sixth factor underlying supply is taxes.
Higher taxes mean higher production cost, and firms are
discouraged to produce more goods and services.
The seventh factor underlying supply is subsidies.
Subsidies are given to firms by the government to help them
maintain their current on desired output. The money received by
the firms effectively reduces their cost of production, and they
are encouraged to produce more goods and services.

The last factor underlying factor of supply is weather.

Weather is considered determinants of supply in the third or
agricultural country like the Philippines. Farmers are very much
dependent on the country’s weather in order to produce more
agricultural products.

G. A change in Supply

If Any of the factors that determine supply change, the

quantity that will be supplied at eachS2price changes.
1.75
S0 S1
Figure 2
1.50
Price
1.25

1.00

0.75

0.50

0.25 61

200 400 600 800 1000

 Quantity

If the supply curve shifts to the right, quantity that

will be supplied at each price increases.

If the supply curve shifts to the left, the quantity that

will be supplied at each price decreases.
(see figure 2)

H. A change in Supply and a Change in Quantity Supplied

A change in quantity supplied is represented by the

movement from one point to another on a fixed supply curve.
This movement shows the change in quantity supplied due to
a change in the commodity’s price, other things remains
constant.

Example:
In figure 3, the price of candy rises from 50
centavos a piece to one Peso a piece. Consequently, the
producers or seller increases the amount produced from
1,000 pieces to 3,000 pieces.

Figure 3
Price
1.75
S
1.50

1.25

1.00

0.75

0.50

0.25 62

1000 3000 5000 7000 9000

 Quantity

Thus, a change in quantity supplied occurs because of a

change in the price of the commodity itself.

A change in supply curve occurs when a factor underlying

supply changes, thus causing a shift of the entire curve.
Producers will be willing to supply a different quantity at each
price.

Example:
The price of sugar and flavoring used for the
producing candies has decreased. Therefore, at each price, the
producers of banana cake will supply more. As shown if figure 4,
the amount supplied at 50 centavos a piece will rise from 1,000
pieces to 3,000 pieces (shift from point x to point y) or the same
quantity will be sold but a lower price.

Figure 4
A change in Supply of Candy

Price

1.75
S0 S1
1.50

1.25

1.00

0.75

0.50

0.25

1000 300063 5000 7000 9000

 Quantity

Major concept

Markets

The term markets is not new to you. We speak of the

super market, the stock market, the market for teachers,
engineers, etc. However, we are going to define the term market
more broadly. We will refer to the market as the arena or
medium in which buyer and seller interact or meet.

This definition is purposely broad since a market need not

be limited to a specific geographic area. For example, the market
for wide-body jet planes such as Boeing 747 or the DC-10 is
world wide. The job market for engineers may include such
diverse location such as Tehran, Iran, Seattle, Washington,
Omaha, Nebraska. In contrast to this, your town may have a
“farmer’s market” which is a specific location where the local
garden farmers bring in their produce during the growing season.

The key element of a market is therefore not it’s location,

but rather the existence of the demanders and suppliers
interested in buying and selling of goods and services.

In an economy such ours, market plays an important role

in determining what will be produce, how production will occur,
and who does the producing. Prices, determined in market, are a
key element in answering this question.

It is in the context of the market that supply and demand

interact to determine price. Once determined, prices are
important mechanism for allocating resources and rationing
goods. In other words, prices help solve economic problems of
what commodities to produce. Prices however, will not be
determined in markets unless certain condition prevail.
64
Condition necessary for price determination

There are some commodities which are bought and sold

in market where there are many buyers and seller. The
organized stock exchange, commodity exchange, and markets
for foreign currencies are examples. At the same time, however,
there are markets which are not as well as organized.

To explain how a market operates, we are going to

construct a simplified model which may not reflect the conditions
of any specific real market ; nevertheless, it will give us insight in
explaining how prices are determined in the real world.

This model is called the model of competitive market and

it operates under the following conditions:

1. There are many buyers and sellers.

2. There is free entry or exit. ( This means that sellers,

for example, may enter the market at will. They are not
prevented from entering by law or custom. ) If this
conditions prevails, it may not be necessary to have
many buyers and sellers actually in the market -- as
long as, the possibility of potential buyers and sellers
entering the market exists.

3. A clearly identified product is exchanged in the market.

This means that the commodity is basically the same
qualitatively.

4. Buyers and sellers have some notion of the prices at

which the product has been selling in the recent past.

Competition as identified by the existence of the above

conditions, is clearly a matter of degree. Some markets then are
more “competitive” than others; therefore, the effectiveness with
which price is determine also differs from market to market.

65
 Finally, we are ready to put the concepts of supply,
demand, and competitive market together. The purpose will be
determine the price of the commodity exchanged.

Market Equilibrium

A market is said to be in equilibrium when the quantity

supplied and the quantity demanded of a commodity are equal.
Table 1 shows the hypothetical market supply and demand
schedules for blank cd’s. There is only one price at which the
quantity supplied equals the quantity demanded. This price is
P20. It is the equilibrium price or the market clearing price as it
also called.
This price can easily be identified in figure 1 as the price at which
the market supply and demand curve intersect.

Notice that the market demand curve and the market

supply curve are plotted on the same graph. The data for the
market demand curve come from columns 1 and 2 of Table 1,
and the data for the market supply curve come from columns 1
and 3 of this table.

At any price above the equilibrium price, a surplus exists;

that is, the quantity supplied is greater than the quantity
demanded. At any price below equilibrium price, a shortage
exists; that is, the quantity demanded exceeds the quantity
supplied.

Table 1
Market Supply and Demand
Blank Cd’s

Price per Blank Total Quantity Total quantity

Cd’s demanded per week supplied per week
P40 1,000 11,000
66
 30 4,000 9,000
20 7,000 7,000
10 10,000 5,000

figure 1
The equilibrium Price and Quantity
For Blank Cd’s as determined by
Market Demand and Supply

Price
40

35

30

25

20

15

10

1 2 3 4 5 6 7 8 9 10 11 12 Quantity

In thousand

Surplus

Note on the schedule or graph the quantity demanded

and quantity supplied when the price of blank cd’s is P40. The
quantity demanded is 1,000 while the quantity supplied is
67
11,000. Therefore, at the price of P40, a surplus of 10,000 blank
cd’s exists.

A surplus exists when at a given price, the quantity

supplied is greater than the quantity demanded.

To prevent their shelves from being overstocked, the

sellers of Blank Cd’s will want to reduce their excess supply of
blank Cd’s. One way to do this is to lower their price. As the price
falls, more people will be willing and able to buy. At P20 the
market will be cleared; that is, the quantity demanded by the
costumers and the quantity sellers are willing and able to offer
for sale will be equal.

Shortage

Note on the schedule or graph the quantity demanded

and the quantity supplied when the price of blank cd’s is P10. the
quantity demanded is 10,000 and the quantity supplied is 5,000.
a shortage of 5,000 blank cds exist at that price.

A shortage occurs when a given price quantity supplied is

less than quantity demanded.

When the price is P10, people will want to buy more blank
cd’s that are available. As the buyers competitively bid up the
price, some will be unable or unwilling to buy at the new prices.
At the low price, manufacturers do not want to supply as much
as demanded. As the price rises, new manufacturers will be
encouraged to begin to supply and old ones will supply more. At
P20, the amount people are able to buy is equal to the amount
manufacturers are willing and able to sell.

68
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 2.1

Identification

________________ 1. it implies willingness and ability to

sacrifice something, money or other commodities in order to
obtain a specific good or service.

_______________ 2. factor of demand that buyers choose

among substitutes guided mainly by price.

_______________ 3. a very important factor of demand

that allows a person to buy more & different kinds of goods.

_______________ 4.. factor of demand that buyers will

increase their purchase of certain goods when their compliments
fall in price.

69
_______________ 5. factor of demand that buyers may
consider the following before they make a major purchase.

_______________ 6. it is a table that shows the quantity

or good or services that is demanded at each different price level
during some specified period of time.

_______________ 7. factor of demand that for any good

at anytime people will depend on the number of units of that
good that already own.

_______________ 8. it is the behavior of suppliers in terms

of the quantity of a commodity that they are willing to sell when
confronted with different prices for that commodity during some
specified time period.

_____________ 9. factor of supply that make possible in the

production of goods & services at lower costs.

_____________ 10. factor of supply that goods maybe

substitute of a complement of a product.

_____________ 11. factor of supply that is added in the

components of cost of production.

_____________ 12. the quantity supplied and quantity

demanded are equal.

_____________ 13. one of the important in cost of

production.

_____________ 14. it pays an important role in

determining what will be produced, how production will occur, &
who does the production.

_____________ 15. factor of supply that the supply of

goods in the market depends on the availability of resources.
70
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 2.2

Multiple Choice : Underline the correct answer

1. it exist when at a given price the quantity

supplied is greater than the quantity demanded:
a. shortage c. market
b. surplus d. equilibrium

2. it occurs when a given price quantity supplied is

lesser than quantity demanded

a. shortage c. market
b. surplus d. equilibrium

3. market is said to be ________ when the

quantity supplied & the quantity demanded of a
commodity are equal

a. shortage c. market
b. surplus d. equilibrium
71
4. it refers to as the arena or medium in w/c buyer
& seller interact or meet

a. shortage c. market
b. surplus d. equilibrium

5. factor of supply that are given to firms by

government to help them maintain their current
of desired output

a. weather c. taxes
b. technology d. subsidies
6. factor of supply that producers consider stiff
competition as challenge to captured the market

a. technology c. price of goods

b. number of producers d. taxes

7. it is a table showing the quantity of any given

product that producers are willing & able to offer
for sale at each possible price during some
specified time period

a. supply schedule c. demand schedule

b. supply curve d. demand curve

8. a change occurs when a factor underlying

supply changes their causing a shift of the
entire curve

a. supply schedule c. demand schedule

b. supply curve d. demand curve

9. it is a table that shows the quantity of good or

service that is demanded at each different price
level during some specified period of time

72
 a. supply schedule c. demand schedule
b. supply curve d. demand curve

10. it is derived by plotting the points from the

demand schedule & joining them

a. supply schedule c. demand schedule

b. supply curve d. demand curve

Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 2.3

True or False

Encircle T if the statement is true, F if the statement is False

T F 1. Demand is purchasing behavior of behavior

when they are confronted with different prices for a specific
goods or services.

T F 2. Demand schedule is a drawing that

represent the demand curve.

T F 3. Law of demand states that as price

increases, quantity demand increase. As price decrease,
quantity demand decrease.

T F 4. Supply is the behavior of consumer who are

willing to supply the market.

73
T F 5. Law of supply states that as price of the
`quantity decrease, suppliers tend to supply more product.

T F 6. Supply schedule is a table showing the

quantity of any given product that producers are willing and able
to offer for sale.

T F 7. Market equilibrium means the quantity

supplied and the quantity demanded of a commodity are rqual.

T F 8. Shortage occurs when a given quantity

supplied is less than quantity demanded.

T F 9. Surplus exist when at a given price, the

quantity supplied is greater than the quantity demanded

T F 10. Market is where consumers and producers

meet.

74
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 2.4

Rewrite the definition of demand in your own words.

75
76
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 2.5

Label the axes, draw a graph, and plot the demand schedule.

Demand schedule form product X

Price per quantity Quantity demanded

1.25 0
1.00 1
.75 2
.50 3
.25 4

77
78
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 2.6

Rewrite the definition of supply in your own word

79
80
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 2.7

Label the axes, draw a graph, and plot the supply schedule.

Supply schedule form product X

Price per quantity Quantity Supplied

1.25 1,000
1.00 850
.75 700
.50 625
.25 450

81
82
Chapter 3 INTRODUCTION TO MICROECONOMICS

ELASTICITY OF DEMAND AND SUPPLY

As we learned in our discussion of demand, the price of a

commodity can greatly influence our behavior as consumers. We
want to take a closer look at consumer behavior. How
responsive is consumers’ demand to change in the price of food.
Medicine, or luxury items such as cars and the like. The measure
of our responsiveness to change in price is called price
elasticity of demand. In this chapter, we will study the price
elasticity of demand, its effects, and its determinants.

We should review the basic concept of demand

The law of demand expresses the relationship between

price and quantity demanded. When the price of a good is
decreased, a greater quantity demanded. When the price of a
good is increased, a lesser quantity of it is demanded. This law
assumes that all other factors underlying demand are held
constant.
83
Introduction to Elasticity of Demand

Although the law of Demand states that as the price of a

good decreases, more of it is demanded, the degree of
responsiveness to a price change will depend on:

 How important the commodity is to the buyer’s

well-being; for example, changes in the price of
medicine, food, stereo, car, or hamburgers will
create different responses.
 The relative degree of the price of the commodity
with respect to the purchaser’s resources or
income.
 The availability of substitute goods.

The degree of sensitivity of consumer behavior to price

changes is called the Price Elasticity of Demand.

1. Demand is Elastic when the relative change

in the quantity demanded of a commodity is
greater that the relative change in price.
2. Demand is inelastic when the relative
change in the quantity demanded of
commodity is less than the relative change
in the price.

You should notice in the definitions of elastic and inelastic

demand that the phrase relative change is important. Elasticity is
a measure of the sensitivity or the responsiveness of changes in
quantities demanded resulting from changes in price. This
responsiveness refers to the degree to which the quantity
demanded changes compared to the amount the price changes.

As consumers, the fact that we demand goods involves

making expenditures when we purchase the goods. Our
expenditures as buyers constitute receipts of revenue for sellers,
where revenue is defined as the amount of money received from
the sale of a commodity. As the first step in explaining the
84
concept of elasticity, we will use the demand schedule to derive
a total revenue schedule. Then we will illustrate total revenue
graphically.

The total revenue schedule

A demand schedule is a schedule which shows the

quantity of a good that will be demanded at each price. A total
revenue schedule can derived from demand schedule simply by

multiplying the quantity of the good that would be demanded at

each price, by the price. Therefore, for every price on a demand
schedule there is a total revenue value. Consider the following
demand schedule: ( see table 1 )

Table 1

A total revenue schedule

(1) (2) (3)

Price Quantity Demanded Total Revenue
8.00 1 P8.00
6.00 2 12.00
4.00 3 12.00
2.00 4 8.00

Every point on a demand curve represents a unique price

and a unique quantity, if you draw lines. If you draw lines
connecting any point on a demand curve to the price and
Pricewill have a negative slope, means line is in
quantity axes, you
decline position. ( see
12 figure 1 )
10
Figure 1
8

2
85

1 2 3 4 5 6 Quantity
 An important implication of elasticity is the effect on total
revenue when price increases or decreases. Let us first look at
the changes in total revenue caused by a price change in the
quantity where demand is elastic. Remember in this case,
changes in the quantity demanded are greater relatively than the
changes in price.

Elastic Demand and Total Revenue

When demand is elastic, a fall in price results in an

increase in total revenue. This is because the loss in revenue
due to a lower price per unit is relatively less than the gain in
revenue due to the greater quantity of sales. In other words, the
response in terms of quantity demanded is very high.

When demand is Inelastic, an increase in price results in a

decrease in total revenue. This is because the gain in total
revenue resulting from the higher unit price is relatively less than
the loss in revenue resulting from decline in quantity sold.

Price
8
7

6
5
4
3

2
86
1

1 2 3 4 5 6 7 8
 Quantity

Inelastic Demand and Total Revenue

When demand is inelastic, a decline in price will cause

total revenue to decrease. The small increase in quantity

purchased will not be enough to make up for the decline in

revenue per unit; therefore, total revenue decrease

When demand is inelastic, an increase in price will cause

total revenue to increase. The gain in total revenue resulting
from the higher unit price is greater than the loss in revenue
resulting from the fall in sales.
Figure 2
Price
10
9
8
7
6
5
4
3
2
1

1 2 3 4 5 6 7 8 9 10 Quantity

Table 2
(1) (2) (3)
Price Quantity Demanded Total Revenue
7.00 2 14.00
5.00 4 20.00
3.00 6 18.00

87
Unitary Elastic Demand and Total Revenue

There is a special case called unitary elastic, this occurs

when an increase or decrease in price does not change total
revenue. In the case of Unitary elastic, the loss of revenues due
to the lower price will just be offset by the increase in revenue,
due to a larger quantity purchased. The gain in revenues due to

the higher price will just be offset by the decrease in revenues

caused by the smaller quantity purchased.

Figure 3

Price
10
9
8
7
6
5
4
3
2
1

1 2 3 4 5 6 7 8 9 10 Quantity

Table 3

(1) (2) (3)

Price Quantity Demanded Total Revenue
10.00 2 20.00
7.00 3 21.00
5.00 4 20.00
4.00 5 20.00
88
 3.00 7 21.00
2.00 10 20.00

It is very important that you understand elasticity and its

effect on total revenue. You will find a chart which summarizes
the three cases we have just discussed.

Summary of Elasticity of Demand and Total Revenues

IF THEN AND DEMAND IS

Price Quantity Total revenue Elastic
Decrease demand increase
increase
Price Quantity Total revenue Inelastic
Decrease demanded Decrease
Increase
Price Increase Quantity Total Inelastic
Demanded Revenue
Decrease Increase
Price Increase Quantity Total Elastic
Demanded Revenue
Decrease Decrease
Price Increase Quantity Total Unitary Elastic
Demanded Revenue
Decrease Constant
Price Quantity Total Unitary Elastic
Decrease Demanded Revenue
Increase Constant

Finally, lets look at two special cases of elasticity of

demand. These two extreme or limiting cases are known as
perfectly inelastic demand and perfectly elastic demand.

89
 When a very large relative change in price causes only a
slight change in relative quantity demanded, demand is inelastic.
The extreme or limiting cases occurs when there is no change in
quantity demanded no matter what the change in price. This
situation is shown by a perfectly inelastic demand curve as in
figure 4.

figure 4 Price
10
9
8
7
6
5
4
3
2
1

1 2 3 4 5 6 7 8 9 10 Quantity

At the other extreme, whenever a relatively small change

in price causes a relatively large change in quantity demanded,
the demand is elastic. Hypothetically, if an infinitely small change
in price causes the quantity demanded to expand immeasurably,
the demand curve is horizontal and is shown by an perfectly
elastic demand curve as in figure 5.

figure 5 Price
10
9
8
7
6
5
4
3
90
2
1
 1 2 3 4 5 6 7 8 9 10 Quantity

So far we have been speaking about elasticity of demand

in general terms. It is much more convenient to have a
quantitative measure of elasticity. This is achieved by computing
the coefficient of elasticity. The two coefficient of elasticity are as
follows:

Economic Approach

Coe= Qd2 - Qd1 P2-P1

------------- ---------
Qd2 + Qd1 P2+P1
------------- ---------
2 2

whereas
Qd1 – Original Quantity demand
Qd2 – New Quantity demand
P1 – Original Price
P2 – New Price

Example:

The price of Pandesal per piece is P1.25. it leads to daily

total sales of 25,000 pieces among the Valenzuela area. The
price then rises to P1.50 per piece which leads to a total sales of
91
22,350 pieces or a reduction in quantity by 2,650 pieces. From
the given data, what is the consumer response with respect to
the changes in price.

Solution:
Economics Method
Given:
Q1 – 25,000
Q2 – 22,350
P1 – P1.25
P2 – P1.50

22,350 - 25,000 1.50 – 1.25 2,650 .25

---------------------- ÷ ---------------- = --------------- ÷ -------
22,350 + 25,000 1.50 + 1.25 47,350 2.75
---------------------- --------------- --------------- -------
2 2 2 2

= 2,650 .25
----------- X ---------
23,675 1.375

= 3,643.75
--------------
5,918.75

= .6 inelastic

Statistic Approach

∆ in QD ∆ in Price
------------------- ÷ ----------------------
Q1 P1

Whereas:
∆ - change
∆ in QD - Qd2 - Qd1
∆ in Price - P2 - P1
92
 2,650 .25 3,312.5
= ------------- X -------- = --------------
25,000 1.25 6,250

= .53 inelastic

In the following demand schedule for banana per piece, the

elasticity are derived the same way using the economic method.

Table 3
Demand schedule for banana per piece

Price per piece Quantity demanded Elasticity coefficient

per week
.50 1
.45 2 6.33 elastic
.40 3 3.40 elastic
.35 4 2.14 elastic
.30 5 1.44 elastic
.25 6 1.00 unitary
.20 7 .69 inelastic
.15 8 .47 inelastic
.10 9 .29 inelastic

Demand curve for banana

Price

.50
.45 Elastic
.40
.35 Unitary Elastic
.30
.25 Inelastic
.20
.15
.10
.05
93

1 2 3 4 5 6 7 8 9 10 Quantity
Note that this demand curve has an elastic, unitary, and inelastic
portion. We can read this from the column showing coefficient of
elasticity.

Interpreting the Coefficient of Elasticity

When demand is elastic and the elasticity coefficient is greater

than 1, the percentage change in quantity demanded is larger
that the percentage change in price

When the demand is inelastic, the elasticity coefficient is less

than 1. this is because a percentage change in price results in a
smaller percentage change in quantity demanded

When demand is unitary, the elasticity coefficient is 1. this is

because a percentage change in price results in an equal
percentage change in quantity demanded

Determinants of Elasticity

 Availability of substitutes:

The more substitute a commodity has, the more

elastic the demand will be for that commodity

If a commodity increases in price and there is

substitute for it, people will switch to the substitute.

94
 If the commodity decreases in price, people will
search for ways to substitute it for a higher price
product.

The demand for commodity will become more

elastic in the long run than in the short run when
price rises, because many adjustment to price take
time to achieve

 Number of uses of the commodity

If a commodity has a number of uses, the demand

for it will tend to be elastic. This is because people
will use it in many different ways as the price
declines.

The demand for a commodity will become more

elastic in the long run than in the short run when
the price falls, because more uses will be found for
a commodity in a longer period of time.

 The necessity of the commodity:

The demand for a commodity that is a necessity

will tend to be inelastic.

 The cost of the commodity relative to the income:

If a commodity takes a larger share of a person’s

income, the demand for that commodity will be
elastic. If the commodity takes a small share of a
person’s income, the demand for that commodity
will be inelastic.

Reviewing the determinants of elasticity

95
 The first determinant is availability of substitutes. Do you
know a commodity that has many substitutes? Going to the
theatre has many substitutes. Consider the following
conversation:

Juan : “ hey, Guys, do you want to go to see the

latest Broadway show? My friend told me that it is worth paying
the Broadway show of Ms. Lea Salonga”.

Carlo : “ No. the price of tickets has just gone up.

I’m going to stay home and watch TV.”

Miguel : “In that case, I’m going to go see the latest

Kristin Hermosa film, it is much cheaper to watch a movie than
to see a Broadway Play “.

Hans : “Spend an added Pesos for a play? No, I’m

going to eat with my girl tonight”.

So you see the demand for a theatre tickets will be elastic

because of the many substitutes available.

The second determinants is the number of uses of a

product.
How many uses do you think a paper clip has? I can think of at
least three. It can be used to keep paper together, of course; it
can be used as a hair curler, and a lock pick. Because it has
many uses, as the price declines for a paper clip, people will use
it in many different ways.

The third determinant of elasticity of demand is the

necessity of commodity. Medicine tends to a necessity especially
if a particular diseases needed a certain medicine. For example,
demand for insulin is inelastic because a diabetic must have it.

The fourth determinant of elasticity of demand is cost of

the commodity, relative to income. If an item takes a small share
of a person’s income, the demand for the commodity will be
96
inelastic. For instance, if salt rises in price, people will still buy it
not only because they consider it necessary for good eating but
also because it takes such a small share of their income. On the
other hand, if stereos increase in price, people will buy fewer
stereos because they are items which take a relatively large
share of income. In this case, the demand for the commodity is
elastic.

Price Elasticity of Supply

Price elasticity of supply is defined as the degree of

responsiveness of sellers to changes in the price of the
commodity. The coefficient of price elasticity of supply measures
the percentage change in the quantity supplied per unit of time,
brought about by a given percentage change in the price of the
commodity.

The interpretation of supply elasticity is similar to those of price

elasticity of demand.

Interpreting the Coefficient of Elasticity

When supply is elastic and the elasticity coefficient is greater

than 1, the percentage change in quantity supplied is larger that
the percentage change in price

When the supply is inelastic, the elasticity coefficient is less

than 1. this is because a percentage change in price results in a
smaller percentage change in quantity supplied

When supply is unitary, the elasticity coefficient is 1. this is

because a percentage change in price results in an equal
percentage change in quantity supplied

Economic Approach

Coe= QS2 - Qd1 P2 - P 1

97
 ------------- X ---------
QS2 + Qd1 P2 + P 1
------------- ---------
2 2

Whereas:
QS1 - original quantity supply
QS2 - new quantity supply
P1 - original price
P2 - new price

Example:

The price of pencil rises from its original price of P4.50 to

P6.25. The producers automatically increase their supply of
pencil from 35,250 to 41,350 pieces per week. What is the
response of in quantity supplied to the change of price.

Economics method

Solution:

41,350-35,250 6.25-4.50
------------------- ÷ ----------------
41,350+35,250 6.25+4.50
------------------- --------------
2 2

= 6,100 1.75
--------------- ÷ -----------
38,300 5.375

= 6,100 1.75
----------- X --------
98
 38,300 5.375

= 32,787.5
-------------
67,025

= .48 inelastic
Statistic Approach

Δ in QS Δ in Price
------------------- ÷ ----------------------
Q1 P1

Whereas:

Δ in QS - QS2-QS1
Δ in Price - P2-P1

= 6,100 1.75
--------- ÷ -------
35,250 4.50

= 6,100 1.75
--------- X -------
35,250 4.50

= 27,450
-----------
61,687.5

= .44 inelastic

99
100
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 3.1

Price
21

18

15

12

2 4 6 8 10 12 14 Quantity
Question 1,2,3 refer to the above figure

1. The total revenue when price is P15 is:

a. 72.
b. 60.
c. 36.
d. 6.

101
2. the reduction in price from 15 to 12 makes a total
revenue:
a. rise
b. fall
c. remain the same
d. equal 0

3. This portion of the demand curve is:

a. elastic
b. inelastic
c. unitary
d. stationary
4. If the demand is inelastic, an increase in price will
cause total revenue to:
a. increase
b. decrease
c. remain the same
d. reverse itself

5. When an increase or decrease in price does not

change total revenue, this is called:
a. elastic demand
b. inelastic demand
c. perfectly elastic demand
d. unitary elastic demand

6. An elasticity coefficient of 2 denotes that demand

is:
a. elastic
b. inelastic
c. unitary
d. unlimited

7. If % change in quantity demanded is equal to 1 and

% change in price
demand is:
a. unlimited
b. inelastic
c. unitary
102
 d. elastic

8. when %change in quantity demanded is equal to 1

% change in Price
Price falls , total revenue will:
a. fall
b. rise
c. remain the same
d. equal 0

9. The following is not a determinant of elasticity of

demand:
a. number of uses of the product
b. availability of substitutes
c. the degree of necessity of a product
d. the number of buyers in the market

10. When an increase or decrease in price does not

change total revenue, this is called:
a. elastic demand
b. inelastic demand
c. perfectly elastic demand
d. unitary elastic demand

103
104
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 3.2

Problem:

The price of gasoline is P24.75 per liter that leads to a

daily sales of 250,000 liters of per week. Due to unstable price of
gasoline, the 3 oil company decided to increase their price.
Additional 25 centavos per liter that leads to a total sale of
202,000 liters per week.

Instruction:

Compute for the elasticity of demand using both method.

105
106
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 3.4

Problem:

The price of chicken is P120.00 per kilo. The department

of trade announce that the price of chicken will increase by 10%.
Suppliers tend to increase their supply from the original 145,000
kilo a week to 170,000 kilo. What is the response when there is a
change in price of chicken.

Instruction:

Compute for the elasticity of supply using both method.

107
108
Chapter 4 INTRODUCTION TO MICROECONOMICS

THEORY OF CONSUMER BEHAVIOR

In the attempt to satisfy wants, consumers make choices

as frequent as wants are felt. Should a person wake up early or
late? Should he eat rice and eggs or rice and dried fish for
breakfast? Play billiards or meet a friend? Call a plumber or do
the fixing himself? These are example of choices that consumers
make and they are important consideration in the study of
consumer behavior? The answer lies on how important are
profits are to the firms.

It is very crucial for firm to synchronize their production

efforts to match the purchasing behavior of consumers. If they
are not able to do so, losses and bankruptcy are highly probable.
In acquiring a working knowledge of consumer behavior,
understanding the concepts of utility are important preliminary
items.

Laws that aim to protect the consumers

109
 Article 1564 ( Civil Code of the Philippines)

The Producers and Sellers is responsible for

whatever promises regarding the product as
a way of attracting the people to buy them

 Article 1574 (Civil Code of the Philippines )

The product should include a guarantee that

it was bought in good condition without any
factory defect or damage

 Article 2187 ( Civil Code of the Philippines )

The producers of food, drinks and any

goods consumed by the body is responsible
to the death of destruction caused by poison
or any substance that can cause disease or
any ailment of the person

 Article 187 of the Revised Penal Code

Anybody who will mark a wrong or fake

karat of gold or silver in any jewelry will be
punished by the Law

 Article 188, 189 of the Revised Penal Code

Anybody who will imitate the packaging or

label of any product will be punished by the
Law

 Republic Act 3740

It is prohibited to advertise or display any

fake product or services

110
 Law of Price Tag

It is imposed on any retail store to display

the price tag of their product

 Presidential Decree No. 187

The metric System will be the standard

measurement to be used in the Philippines

 Republic Act 3452

The establishment of National Food

Authority to buy grains of rice and corn from
the farmers and sell to the consumers at low
price

 Republic Act 4729

It is prohibited to buy deregulated drugs

without doctor’s prescription

 Republic Act 5921

The sellers of medicines and poisons are

responsible for the broken zeal of the
container

 Republic Act 3595

The Producers and Sellers of galvanized

sheets must mark clearly the thickness, zinc
coating, name and address of its producers

 Republic Act 1929

111
 It is prohibited to sell any form of acetic acid
in any grocery of sari-sari stores

CONSUMERS RESPONSIBILITY

 Pay the product bought on the exact time that it

was agreed upon
 Don not waste the products bought to avoid
shortage and a consequent increase in its price
 Minimize buying imported goods to avoid the
depletion of dollar reserves and also protect the
interest of the local producers
 Patronize the local Products
 Ask for receipts to make sure that the
sellers/producers are paying taxes
 Report to the authorities any violation of the right of
the consumers
 Be vigilant in maintaining the price and report any
violation on price padding

The Concept of Utility

It is normal to have individual wants and desires to satisfy

those wants. In this regard, he already has a set of preferences
for goods and services and if not, he is on his way to preparing
one. So, how then is a consumer able to establish a set of
preferences for goods and services?

The concept of utility is very in providing answers to the

above – cited question.

What is UTILITY?

In analyzing consumer choice, economists use the term

utility to indicate the amount of satisfaction an individual or
household receives from consuming a particular product. Be
careful not to confuse the economic meaning of utility with a

112
product’s usefulness, as used in everyday speech. You may get
the same amount of satisfaction (economic utility) from buying a
diamond ring or putting extra insulation in your house. The
insulation might be more useful in a particular sense, but
usefulness is only one aspect of satisfaction.
Utility is a boarder concept than usefulness. You can
derive satisfaction, or utility- including ego gratification, status,
and security- from a product’s beauty, quality, comfort, durability,
prestige, service, convenience, or function, even though the
product may not be very useful. This distinction is important to
businesses. Adding any feature to a product that increases utility
can increase quantity sold. When economists say that consumer
choice is influenced by utility, then they mean that choice
depends on the satisfaction individuals expect to get from a
product they buy.
Our objectives in this chapter is to understand
consumer demand: the trade-off between price and the quantity
that an individual will purchase. Putting the concept of rational
consumer choice utility terms, we can say: (1) the goal of a
household is to maximize the total utility, or benefits it receives
by spending its funds; and (2) in order to determine what to buy,
individuals compare the marginal utility (MU), or extra
satisfaction, from one product with that they could receive from
some other purchase.
Measuring Utility

The pleasure of satisfaction derived from using a product

or service is psychological and thus, is incapable of
measurement in absolute terms. The problem of measurement
must be hurdled however, if one wants to proceed with
understanding the principles of economic behavior. I n this
regards, economists have proposed two ways of measuring
utility: (1) the cardinal utility approach, (2) the ordinal utility
approach.

The cardinal utility approach refers to the measurement of

utility by assigning numerical values, referred to us utils, such as
1 util, 100 utils.
113
 The 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.

The Concept of Marginal Utility

The satisfaction of human wants is a purpose of using

products and services. Individual persons obtain satisfaction at
increasing levels as they consume the product or service in
succession. This means that the total utility of the product or
service increases as more units are consumed. This increase in
utility is called marginal utility. In more precise terms, marginal
utility refers to “the satisfaction an individual receives from
consuming one additional unit of good or service.”

Table 1
Schedule of total and marginal Utility
For Juan dela Cruz

Bananas Total Utility Marginal utility

Consumed
1 50 50
2 90 40(or 90-50)
3 110 20(or 110-90)
4 120 10(or 120-110)
5 90 -30(or 90-120)
6 10 -80(or 10-90)

114
 Table illustrates the concept of marginal utility applied to
Juandela Cruz’s consumption of bananas. The total utility
derived by Juan in consuming a piece of banana is 50 utils. His
total utility for consuming the second banana is 90 utils. The
second banana generated a marginal utility of 40 utils. The
fourth banana gave Juan a total utility of 120 utils but with a
marginal utility of only 10 utils. This indicates full satisfaction of
Juan’s need for bananas at that particular time.

Total utility declined at the fifth and sixth bananas, as

Juan felt satisfied. The total utility and marginal utility curves are
depicted in Figures 1 and 2. It is important to take note that
marginal utility decrease as more pieces of bananas are

consumed. This is an illustration of the law of diminishing

marginal utility. Specifically, the law states that “the amount of
extra or marginal utility declines as a person consumes more
and more of a good.”

Figure 1

115
Consumer Equilibrium

Consumers are expected to behave in a rational manner,

i.e., they make decisions on the basis of choosing which
alternative would be most advantageous to them. Decision-
making, however, will be simple if the consumer wants only a
single good at a given time. This is not realistic, however,
because consumers find it necessary to buy a variety of goods.
This will make his decision- making a little complicated as he has
to determine which goods to buy and at what quantity. To
complicate matters, the consumer is faced with the following
realistic:

Figure 2

50

40

30

20

10
Marginal Utility
(In Utils) 0

10

20

30

40

50

60

70

80 116
90
1 2 3 4 5 6
 Quantity
(In Pieces)

1. the varying prices of goods competing for his attention,

and
2. the limited income or purchasing power he has.

The consumer cannot buy everything he wants because

of his limited income. Rather, he has forced to
compromise and decide what and how much of each of
the many items he can afford and will best suit his needs.
The most preferred combination of goods to buy is
referred to as consumer equilibrium.

Utility Maximization and Consumer equilibrium

It is expected that the rational consumer will attempt to

choose an option that will offer him maximized utility. Let us
assume that Juan dela Cruz is determining what combination of
two goods, ice cream and chocolate bar, must she purchase for
him to obtain maximum satisfaction with her limited fund of
twenty pesos . Juan is confronted with the price of ice cream at
P2 per cone and P4 for a bar of chocolate, regardless of how
many are bought. From Juan’s point of view, the utility of the two
items in various quantities is shown in Table A and B.

MUx = MUy
----------- ---------
117
 Px Py

Whereas:
MUx - Marginal Utility of product X
MUy - Marginal Utility of product Y
Py - Price of product Y
Px - Price of product X
Formula:

MU = ΔTU
---------
ΔQ

MU = TU2 - TU1
----------------
Q2 - Q 1

Assumptions:
Budget - P20
Px - P2
Py - P4

Table A
Product X (ice cream)
Price: P2
Q TUx MUx MUx/Px
1 11 11 5.5
2 20 9 4.5
3 28 8 4
4 35 7 3.5
5 41 6 3

Table B
Product Y (chocolate bar)
Price: P4
Q TUy MUy MUy/Py
1 25 25 6.25

118
 2 46 21 5.25
3 64 18 4.5
4 79 15 3.75
5 90 11 2.75

MUx = MUy
----------- ---------
Px Py

9 = 18
------ ------
2 4

4.5 = 4.5

Indifference sets and Curve

Indifference set for food and clothing (a)

Figure 2.1

Combination Food Clothing

A 28 8
B 18 9
C 15 10
D 9 18
E 8 24

Indifference curve for

28 food and clothing (b)
24
Figure 2.2
20 A
Units of Food
16

12
8 B

4 119

5 10 15 20 25 30 35
 C
D
E

Units of Clothing

Figure 2.1 and 2.2, shows the combinations of food and clothing
that would give Amor Daniel identical amounts of satisfaction.
That is, Amor would be as happy with 8 units of clothing and 28
units of food (combination A) as she would with 18 units of
clothing and 9 units of food (combination D). Note that we are
not saying that these combinations provide her with the
maximum satisfaction she can buy with her current income, but
only that Amor finds each combination equally satisfactory.

INDIFFERENCE SETS AND CURVES

Faced with having to choose among the various combinations

shown in Figure 2.1 and 2.2, Amor would be indifferent because
each combination gives her the same level of satisfaction, or
total utility. For this reason, economics call the data in Figure 2.1
(a) an indifference set, indicating that Jennifer has no particular
preference. The plot of these data, shown in Figure 2.2 (b), is
called an indifference curve. Any point along indifference curve
I1,for example, represents an identical level of total utility to
Amor.

We can learn more about Amor’s relative preferences for

food and clothing and about indifference curves in general by
examining the data more closely. In looking at the different
combinations, you can see that Amor is willing to sacrifice some
clothing to obtain more food, and some food to obtain more
clothing. In fact, she must do without some food in order to buy
more clothing, if her total satisfaction remains constant. Thus

120
the slope of an indifference curve is always negative (assuming
that the buyer prefers more to less of each good).

Amor preferences also follow the law of diminishing

marginal utility: The amount of food that she is willing to sacrifice
for clothing declines as the quantity of clothing already obtained
increases. For example, moving from combination A to
combination B, she is willing to give up 10 units of food to obtain
1 more unit of clothing. But moving from B to C, she is willing to
give up only 3 units of food. Thus the marginal utility of clothing
and food declines as she acquires more and more. Graphically,
the law of diminishing marginal utility causes the indifference
curve to flatten out as it approaches each axis.

We also noted in this chapter that the choice between two

products depends on the relative value that a buyer places on
additional quantities of each. To measure this relative value,
economists use a concept known as the marginal rate of
substitution. It is measured as the quantity of one good (for
example, food) that a buyer is willing to sacrifice to obtain an
additional unit of another good (for example, clothing), holding
total utility constant. Mathematically, we express it as.

Marginal rate of substitution = Change in quantity of product A

Change in quantity of product B

Figure 2.1 and 2.2 shows that between combinations A and B,

Amor’s marginal rate of substitution is 10 units of food for 1 unit
of clothing. That is,

Change in quantity of food = 10 = 10

Change in quantity of clothing 1

Between combinations D and E, the marginal rate of substitution

is 6 units of clothing for 1 unit of food, or

Change in quantity of food = 10 = 0.17

Change in quantity of clothing 6

121
 We can also equate marginal rate of substitution with the
ratio of the marginal utilities of the two products. For example,
Amor is willing to sacrifice 3 units of food to get 1 more unit of
clothing in moving from B to C. She is indifferent to the two
combinations which suggests the value (marginal utility)
of clothing is 3 times that of food. On the graph, the absolute
value of the slope of the indifference curve at any point
measures the marginal rate of substitution or the ratio of the
marginal utilities of the two goods.
BUDGET CONSTRAINTS

Knowing Amor’s preferences is not enough to tell us how much

food and clothing Amor will choose to buy. We must also
recognize that she cannot have everything she wants. Her
choices are limited by two factors: her income and the prices of
food and clothing. We want to see how, within these limits, she
will decide what to buy.

Figure 3.1 shows Amor’s budget constraint. She can

purchase alternative combinations of food and clothing on her
income of P300 a week and at prices of P20 a unit for food and
P30 a unit for clothing. If she spent all her income on food, she
could buy 15 units of food but no clothing. She could also buy
10 units of clothing and no food. Or she could choose various
combinations between the extremes. The budget constraint line
shows possible combinations but not which combination is best.
Moreover, Amor can purchase more food only if she sacrifices
some clothing. That is, she cannot attain any combination to the
right of the budget constraint line. Note that the absolute value
of the slope of
20 the budget constraint line measures the ratio of
the two prices.
18 Figure 3.1
16
Units of 14
Food at P20
12
10
8
6
122
4
2
2 4 6 8 10 12 14 16 18
 Units of
Clothing at P30

Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 4.1

Graphically plot the given

Q 0 1 2 3 4 5 6 7 8 9 10
Tux 0 14 26 37 47 56 64 70 74 77 78
MUx 0 14 12 11 10 9 8 6 4 3 1

123
124
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 4.2

Graphically plot the given

Q 0 1 2 3 4 5 6 7 8 9 10
TUy 0 13 24 34 42 49 55 58 60 60 55
MUy 0 13 11 10 8 7 6 3 2 0 -5

125
126
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 4.3

Mommy Alice has a choice of consuming eggs or pancakes for

breakfast. Her utility schedule for the two foods is.
Assumptions:
Budget P55
Price x P 4
Price y P 8
Required: Compute for the Marginal Utility for the product.

Eggs
Product x
Quantity TU MU MU/P
1 90
2 150
3 186
4 204
5 216
6 225
7 231
8 234

127
 Pancakes
Product y
Quantity TU MU MU/P
1 70
2 100
3 120
4 134
5 144
6 152
7 156
8 158

128
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 4.4

Plot graphically your answer in exercise 4.3

129
130
Chapter 5 INTRODUCTION TO MICROECONOMICS

THEORY OF PRODUCTION

The process of production in the market oriented

economy appears to be chaotic and unorganized. Many
individuals make decisions as consumers and producers which
somehow ultimately determine what the economy produces in
the aggregate. Complex and confusing as this system may first
appear, there are number of organizing principles which provide
insight into understanding how competitive market economy
operates. In order to achieve the goals society establishes for its
economic system, it is important to understand how it functions.

Major Concepts

A tale about diminishing marginal returns

The following stories, although somewhat far-fetched, will

introduce you to the concept of diminishing marginal returns.

131
 Once there was a king who had a large palace, lovely
family, many servants, and loyal subjects. But this king had an
obsession. He loves gold coins. Even on beautiful days when the
weather was warm and sunny, he would hide in the cellar
counting his coins.

One day he called his Prime Minister to the throne room

and said,

“My treasure of gold coins has increased only 500 this

year. I want more”

The Prime Minister, fearful of losing his job, replied,

“Your majesty, I have only ten men digging in the mines.

How can I find more gold with that many
men?”

“I give the permission to add ten more worker. Now get

that gold to me!”

So the additional men started working. During the next

year, a total of 600 coins arrived at the king’s palace, only 100
more than the previous year.

The king counted them. He was furious.

“Only 600 coins,” he shouted. “You’ve added ten men to

the mine and have increase my annual
output of gold by only 100. I want more immediately.”

So the Prime Minister added ten more men to the mine.

The workers shoveled and shoveled but they kept

bumping into each other, and fights would break out because of
the crowded conditions. During the next year, 675 coins arrived
at the palace.

The king called in his Prime Minister again.

132
 “I have given you ten more workers and receive only
seventy-five more coins than last year. They
must be slacking off.”

“But your majesty! The men are working as hard as they

can. Give me another chance.”

The king really liked his Prime Minister and didn’t want
to get rid of him, so he said,
“I’ll give you one more chance. I’ll give you ten more
men to put in the mine. But if the next year
you don’t produce at least 800 coins, you will be killed.”

The trembling Prime Minister brought ten more men to

the mine. The men shoveled as hard as they could. At the end of
the year the Prime Minister arrived at the palace, but this time he
had a total of 725 coins for a whole years work. This was only 50
more coins than last year. And as you might guess, the prime
minister lost his head.

After you finished this minicourse, you should be able to

advise the king why he was obtaining less extra output for each
additions of ten men to the mine. Read now about fixed and
variable inputs and return their relationships in light of the law of
diminishing marginal returns.

Law of Diminishing Marginal Returns

A. Fixed and Variable Inputs

In the production of commodities, many resources are

used. As output is increased, however, differing combinations
of resources can be used to achieve this added output. In the
short run, some resources are not increased as easily as
others, in agricultural, for example it is usually easier to
increase the use of fertilizer than to increase the amount of
land. In a small business, the plant space is often difficult to
increase, in the specialized industry, the limited resource
133
maybe highly specialized machinery. These limited
resources are called fixed inputs because their level cannot be
increase readily, i.e., in a short run period of time. A variable
inputs, in contrast, is one which is readily available and one
whose level can be adjusted quite easily to suite the procedures.

For example, in agriculture, farm land is a fixed input

in the short-run and fertilizer is a variable input. The output
maybe sack of grains. In other industries, the fixed input maybe
the factory and the variables input maybe the number of
laborers. The output is perhaps an automobile, a toy, or some
other product. An input “closer to home” maybe the number of
hours you spend studying economics; the output may be your
understanding of economics.

B. The Law of Diminishing Marginal Returns states that the

relationship between inputs of a production process and the
output produce in short run.

In the most production processes, the total output will

increase when the variable input is increased with other input
fixed. The additional output obtained from each additional unit of
variable input is called the marginal return. After a certain point—
the point of diminishing marginal returns—this marginal return
becomes less with each additional unit of variable input.

The Law of Diminishing Marginal Returns states that when

successive unit of variable input used with a fixed input
beyond a certain point, the additional product produced by
each additional unit of variable input decreases.

C. Here is a description of a production process which

illustrates the law.

134
The fixed inputs in this example are the amount of land- - say 10
hectares- -ten tons of fertilizer, and two tons of seed. Labor is the
variable input.

If there is no labor on the land, of course, the resulting total

output will be zero sack of corn.

If we add one laborer to farm the land, a total of 750 sacks of

corn is produced.

Add a second laborer to farm the land, the total is 2000 sacks of
corns.

Add a third laborer to farm the land, the total is 2500 sacks of
corn.

Add fourth laborer to farm the land , the total is 2700 sacks of
corns.

Add a fifth laborer to farm the land, and the total is 2800 sacks
of corns.

Add a sixth laborer to farm the land, and the total is 2800 sacks
of corn, the same output as with five laborers.

Formula:

Total Product (TP) - is the total amount produced during the

Specified period of time

Average Product (AP) – is the total product per unit of the

Variable input.

AP = TP
--------
VI

135
Marginal Product (MP) – the change in total product per unit
Change in the quantity of the variable input.

MP = Δ TP TP2 - TP1
--------------- = ----------------
ΔV I VI2-VI1

whereas:

VI – variable Input
MP – Marginal Product
AP – Average Product
TP- Total Product

See Table 1 for a systematic representation of the data. It list the

marginal or extra output resulting from each additional laborer.

Table 1
Schedule of Marginal Returns

No. of laborer Total product Average Marginal

product product
0 0
1 750 750 750
2 2000 1000 1250
3 2500 833.33 500
4 2700 675 200
5 2800 560 100
3000
6 2800 2800 466.66 0
2600
2400
2200 Figure 1
2000
TP, AP, MP
1800
1600
1400
1200 TP
1000
800
600
400 136
200

1 2 3 4 5 6
 AP
MP

Notice on Table 1 that each time one additional laborer is added,

the total product increase. Look at column 3 . the 750 is obtain
by taking the different between the 0 and the 750 from column 2.
The 1250 in column 3 is obtain by taking the difference between
2000 and 750 in column 2. The 500 in column 3 is obtained by
taking the difference between 2500 and 2000 in column 2, and
so on. Note in column 3 how the marginal or extra output at first
increase but then decreases. The point of diminishing marginal
returns occurs with the hiring of the third laborer, because at this
point the extra output diminished from 1250 to 500 bushels. After
this point, the marginal returns keep decreasing.

D. The curved in Figure 1 is obtained by plotting the total

product by the number of laborers on the job, using data
from Table 1.

Note in Figure 1 that the amount of the total product does

increase, at first quite steeply, and then slows down until no
increase is achieved with the sixth worker. Therefore, as stated
in the first part of the law, if the variable input (labor) is
increased, increases in production(of corn) are possible, but the
increase eventually decreases. In other words, the increase
occurs in smaller and smaller amounts.

E. The curve shown in Figure 2 is obtained by plotting the

extra output or marginal output of corn on the vertical axis
and the additional units of labor on the horizontal axis,
using data from Table 1.

137
Note in Figure 2 that when the second laborer is added, the
marginal output is 1250 bushels of corn. But with the additional
of the third laborer, the marginal output is much less. The point
of diminishing marginal returns is past. Beyond this point, less
and less extra output is produced with the addition of each
worker. Therefore, extra output decreases from a high of 1250 to
a low of zero bushels of corn with the sixth worker.

Notice when 3 laborers are used and the point of diminishing

marginal returns is reached., it can be seen by a more gradual
rise in the total product curve. Also notice that when six laborers
are used, marginal returns become zero. This worker add
nothing to total output; hence our total output curve levels off at
this level.

F. This element is important in understanding the Law of

Diminishing Marginal Returns. The short run is a period in
which only variable input can be altered. In a longer
period of time, called the long run, even resources, which
were previously fixed, can be increased. Thus, the long
run when all inputs are variable, there are no diminishing
returns because there no longer exist a distinction
between variable and fixed inputs. Consider first the
following short-run situation in which only one input is
variable. If you increase this input, the effect on total
output will be described by the typical total output curve.
See Figure 3.

In Figure 3, fertilizer is the only input varied. It is clear that at

some point the marginal output diminishes. If, however, the
example is change in the fundamental way by allowing all inputs
to be varied, a completely new situation arises. If, for example,
all the formerly fixed inputs are doubled, the amount of fertilizer,
which brought on diminishing marginal returns in the short run
will no longer cause that effect. The amount of the other inputs
has been increased; therefore, diminishing returns to fertilize will
not occur until a much greater amount of fertilizer has been
138
used. See table 2, which shows the short run total production of
corn when only one input is variable and the long run total
production of corn when the fixed inputs have been doubled.
See Figure 4 which shows the resulting curves from this
schedule.

G. Substitution of Resources
In the process of production, resources are often
substituted for each other. A substitute input is anything
which can be used in place of another input. For instance,
coal and oil may be substituted for another in the
production of electrical energy. A serious situation arises
in the economy in which a limited resource does not have
a substitute readily available. If this occurs there may not
be enough of a fixed resource to allow production to
expand in the long run. For instance, a country may be an
island with a limited supply of land or a country may have
a lack of rainfall or sunshine. Where no substitute is
available to increase this fixed resource, the expansion
necessary for the well-being of the country is prevented
by diminishing marginal returns. Thus, the country will be
forced to import this product. Therefore, is substitutes are
scarce, production cannot be expanded in long run.

The other problem related to the Law of Diminishing Marginal

Returns is efficiency. Even though a producer would like to
expand, he must consider the physical size(or other factors of
the input) he must add to his operation. For instance, machinery
for a factory or tractors for farms are of such a size that they
determine the least size of the operation. Therefore, more than
one input maybe necessary for expansions. This may
necessitate expansion of the factory to house the machinery or
additions of acres for a farm to fully use tractors. Thus, though a
producer may want to expand in the long run, he may become
involved in more than one aspect of expansion to use his
resources most efficiently.

139
Lets think back to the tale at the beginning of this lesson. What
might the prime minister have done at the mine to increase
production long run?

Well, he might have ordered new machines to work the mine—at

least shovels. He might have opened up new passages to the
mine or look for a new areas to mine. All these actions would
have increase production more than just adding men. It would,
however, have taken more time.

140
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 5.1

Multiple Choice

_____ 1. The law of diminishing returns applies to situations in

which
a. all factors of production are varied together
proportionally.
b. factors are substituted for one another.
c. one factor is varied while the other factors do not
change.
d. all factors are fixed.

_____ 2. The marginal product of labor is the change in

a. average product when more labor is added and capital
is taken away.
b. total product when more labor is added and capital is
also increased.
c. average product when one more worker is added and
capital remains unchanged.
d. total product when one more worker is added and
capital remains unchanged.

141
_____ 3. Diminishing returns set in when
a. the marginal product starts to fall.
b. the average product starts to fall.
c. the total product starts to fall.
d. MP = 0.

_____ 4. The marginal product of capital is the change in _____

when one more K is added and L _____.
a. total product; is unchanged
b. average product; is unchanged
c. average product; is also increased
d. total product; is also increased
_____ 5. MP = AP when
a. average product is lowest.
b. average product is falling.
c. marginal product is rising.
d. average product is highest.

_____ 6. A decrease in wages will

a. reduce MP but leave AP unchanged.
b. reduce AP and TP.
c. increase MP and AP.
d. not affect MP and AP.

_____ 7. Marginal cost is lowest when

a. MP is lowest.
b. MP is highest.
c. AP is highest.
d. AP is lowest.

_____ 8. Average cost is lowest when

a. MP is lowest.
b. MP is highest.
c. AP is highest.
d. AP is lowest.

_____ 9. Returns to scale occur when

a. factors of production are substituted for one another.
b. all factors are varied proportionally.
142
 c. one factor is varied while the other factors do not
change.
d. one factor is fixed.

_____ 10. A firm produces 500 bandanas per day using 4

workers and 6 machines. When it adds 3 more machines and 2
more workers, the firm expands its output to 1,000 bandanas per
day. This firm is experiencing.

Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 5.2

Compute for AP and MP

Q TP AP MP
0 0
1 100
2 250
3 380
4 480
5 570
6 650
7 720
8 180
9 830
10 870
11 900
12 920

143
144
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 5.3

Plot your answer in exercise no. 5.2

145
146
Chapter 6 INTRODUCTION TO MICROECONOMICS

COST OF PRODUCTION

The producer in this course is presented as done whose

objective is profit and is maximization. To attain this objective,
the producer is equipped with explicit concepts as discussed in
the chapter in order to arrive at a more refined and rational
decision. Moreover, these concepts serve as a basis in
understanding the producers market behavior as discussed in
the succeeding chapters.

The framework of this chapter’s discussion is the concept

of business which defines cost and profit. This definition serves
to identify the components of cost-output as well as revenue-
output relationships which in turn lead to the concept of
maximum profit.

Profit can be attained by organizing the business

according to the owners’ objectives and resources. Ownership
of a business may be vested in a person as a sole proprietor,
among two or more individuals as partners, or in a separate legal
147
entity known as corporation. Sole proprietorship is an enterprise
owned by a single individual who alone benefits from the profits
or suffers the losses. A partnership is the agreement of two or
more persons who bind themselves to contribute money,
property, or business know-how to a common fund with the
intention of dividing profits or losses among themselves. A
corporation is an artificial being created by operation of law,
having the right of succession and the powers, attributes, and
properties expressly authorized by law or incidents to its
existence.

The three forms of business organization mentioned in the

aforementioned paragraph are the basic ones. Two other forms,
the cooperative association and the syndicate, may also be
mentioned. The cooperative association is a non-profit
enterprise, owned and democratically controlled on a mutual
basis by its members who participate in the savings generated
by the cooperative in proportion to the patronage given by the
individual member to the association. The business syndicate is
organized by several corporations to carry out a particularly large
project, the syndicate being dissolved when the purpose for this
organization has been realized. Syndicates are formed when the
purpose is for a transaction or a contract too big for the
resources of a single corporation, such as the underwriting of a
multi-million peso securities issued by a group of investment
houses, or the construction of a big naval base by a group of
building contractors.

A. General Concept

From the point of view of an entrepreneur, a business or firm

exist to reward entrepreneurial efforts. To render this reward, the
firm undergoes a production process, the outcome of which
serves the consumers or buyers. Production embraces the
whole process of making the product available to them which
therefore, includes the final process of distribution. In so doing,
the firm pays a price by expending its stock of assets and the
value foregone is called cost. At the end of the said process, the
firm earns revenues through the sale of goods or services. The
148
positive net effect or the positive difference between revenue
and cost is called profit and accrues as the said reward of the
entrepreneur.

Hence, profit is a creation of entrepreneurship With the

revenue earned, the firm can recover what it foregoes in the
process of production and the excess is simply the profit created.
To retain this profit is to increase the firm’s stock of assets.
Conversely, the negative difference between revenue and cost
results in a loss which erodes this stock of assets.

Short run refers to a period of time in which the quantity

of machines and equipment cannot change because of the time
allotment, yet long enough to make a change in its variable
resources. It is also a time in which one of the input is fixed
while the rest are variable. Variable input is a factor used in
production that can differ in the short run, while the inputs that
cannot be changed are called fixed inputs.

Long run refers to a period of time which is long enough

for all the inputs to be changed and varied. This is a case in
which all inputs are variable, and cost of production is likewise
variable.

Rationale

Price is an important factor in a market oriented economy

such as ours. It determines what and how much people will buy.
It also determines what services people will sell and where and if
they will be employed. Most important for this chapter, however,
is that the price of an output and the price of inputs, together with
the rate of productivity, help determine what resources will be
used, how they will be used, and how intensively they will be
used. The level of an input, such as labor, is therefore
determined to a considerable degree by the value of its marginal
product.

Prerequisites

149
The chapters of “diminishing Marginal Returns,” “demand and
supply”, and “Equilibrium” or their equivalents are prerequisites.

Introductory Comments

Assume that you are one of many competitive producers

of a commodity. Undoubtedly you will want to maximize your
profits, and in doing so you will have to consider many things.
Not only must you consider the market demand for your
commodity, but also you must consider the cost of inputs.
Remember, as mentioned in our discussion of the law of
diminishing marginal returns, that some input factors will be fixed
and others will be variable. One major variable input you will
need to consider is labor. How many laborers should you hire?
What wage should you pay? How can you determine the value of
each additional worker you hire?

We will attempt to answer such question in this chapter

by explaining how much a variable input will be paid in the
competitive model of a market economy when only one input is
variable.

Major Concept

The following interview may help introduce the concept of

the value of marginal product.

Hans: “Hello. This is Hans reporting to you from

Makati. We are on the scene of the strike at
Honda cars factory. Lets talk to a striker. Mr.
Jorenz, what are you striking for?”

Jorenz : “we want higher wages. The way things are

going, I’m not going to be able to buy
clothes and food for my family. The trouble
with management is they want to keep all
the profits for themselves.”

150
 Hans : “thank you. Lets talk to this woman standing
on the corner. Excuse me ma’am, are you
on strike also?”

Ina : “Are you kidding? I don’t have a job. I’d like

to be able to work but the company wont
hire me. In fact, they are laying off people.”

Hans : Now lets talk to Mr. Philip , a top manager at

the Honda Cars. Mr. Philip, what is
management’s view of the strike?”

Philip : “We are against the strike. We are already

paying the highest wage in the city and we
have to make a reasonable return on our
investment. Labor doesn’t seem to
appreciate that the more we pay them, the
fewer of them we can employ. Also, our
other expenses are rising.”

Hans : ‘Thank you, Mr. Philip. We now have heard

two sides of the arguments. Labor wants
more money and management wants to
make a profit.”

How will this strike be settled? An important factor in the

settlement is the productivity of the workers. The concept, the
value of marginal product, will help us measure the contribution
of each worker hired.

As a review, let us first look at the Law of Diminishing

Marginal Returns and the definition of the marginal product.

A. The law of Diminishing Marginal Returns states that as

units of a variable input are added to fixed resources, beyond
some point the output generated by each additional unit of the
variable resources will decline.

151
 8. The amount of additional output that is produced
when one unit of a variable input is added to the
fixed input is called the marginal product.
9. After the point of diminishing marginal return is
reached, each added unit results in a smaller
marginal product.

The following schedule shows a variable input – labor in this

example, the total product – pencil, and the marginal product .
the marginal product is obtained by recording the additional to
total product is the last unit of input used. For example, when
input is increased from 4 units (labor) to 5 units (labor), the
additional to total product is obtained by subtracting 700 from
900; that is, 200 is the marginal product to the 5 th unit.
Subtracting 900 from 1050 yields 150 which is the marginal
product of the 6th unit of input, etc.

Table 1
Schedule for pencil

Units of variable Total product Marginal product

inputs (labor) (pencil)
4 700
5 900 200
6 1050 150
7 1150 100
8 1210 60
9 1240 30
10 1260 20

Notice in table 1 that the total product at each level of

input used is obtained by adding the output of all laborers at that
level. The Marginal Product is obtained by subtracting one total
product from the next total product. Also notice that the amount
of marginal product diminishes as each additional laborer is
employed.

152
 Until now we have only recognized the existence of the
marginal product , remembering that eventually it begins to
decrease. We now need to concern ourselves with the marginal
product by determining its value.

B. To find out what the value of the marginal product is, multiply
the amount of marginal product by the price of the product.
Assume that the price of pencil is P5. in table 2, when the
fifth laborer is employed, the value of the marginal product is
the marginal product (200) multiplied by the price of the
product, P5, yielding P1000. for the 6 th laborer , the value of
the marginal product is 150 x 5, is equal to P750

Table 2
Schedule of Value of Marginal Product per day

Units of Marginal Price of Value of

variable input Product Product Marginal
(laborer) Product
5 200 5 1000
6 150 5 750
7 100 5 500
8 60 5 350
9 30 5 150
10 20 5 100

The value of marginal product is an important consideration

when deciding the number of inputs needed to produce a
commodity. In this chapter, we will consistently use labor as our
variable inputs, although any other variable input could be used.

C. The value of Marginal Product is important on the decision

concerning the number of inputs of be used form producing a
commodity. Let us take the case of labor. Assume a worker
earned P280 a day. How many workers will the manufacturer of
pencil hire? In order to answer this question, we have to know
what the employer’s cost are at all levels of output and what his
153
receipts or revenues are at all level of sales. His total profit will
be greatest when his total receipts or revenues exceed his total
costs by the largest amount.

His revenues at each level of sales will depend on the

price of the product being sold. For example, if the market price
for a certain good is P10, the total revenue received will be equal
to the number of units he sells times P10. similarly, if the market
price is 20, total revenue will equal P20 times the number of
goods he sells. In short, total revenue is equal to the product of
price times the quantity of good sold. Total cost will vary with
output. The larger output, the larger total costs. The costs
increase with output, since larger output requires more inputs

and each inputs has a cost. The nature of the relationship among
revenues, costs and inputs will determine what happens to profit.
(See table 3) When the employer hires the 5 th worker, his net
gain or additional to total profit is P75; the worker’s output is
worth P100 and he is paid P25. (P100-P25 =75) when the 6 th
worker is hired, the manufacturer gain P50 because the worker’s
output is worth P75 and he is paid P25. (P75-P25=P50)

Table 3
Schedule Showing Gain or Loss
To manufacturer when wage is P280 per day

Labor Value of Price of Input Profit

Marginal (Wage) (Gain or Loss)
Product
(per day)
5 P1000 P280 P720
6 P750 P280 P470
7 P500 P280 P220
8 P300 P280 P20
9 P150 P280 P-130
10 P100 P280 P-180

154
C. A producer who wants to maximize his profit will use
units of a variable input until the point is reached at which the
value of marginal product no longer exceed the input price.

Now we will compute the cumulative profit that the producer

earns. See table 4 in which profit is cumulated in the last column.
Add P720 toP470 to obtain P1190, P1190 added to P220 to
obtain 1410, P1410 added to P20 to get P1430, and so on.

Notice that in terms of cumulative profit, the producer will

hire only 8 workers. Past this point, profits will begin to decrease.

Table 4
Schedule Showing Cumulative Profits

Labor Value of Profit per day Cumulative

(units of Marginal profit
variable Product
inputs) (per day)
5 P1000 P720 720
6 P750 P470 1,190
7 P500 P220 1,410
8 P300 P20 1,430
9 P150 P-130 1300
10 P100 P-180 1,120

Producers will never hire an additional unit of input if the

price they must pay exceeds the value of the marginal product of
that input.

D. The value of marginal product curve is a firm’s demand curve

for variable input such as labor. The value of marginal
product curve is illustrated in figure 1. Note that the curve,
like all demand curves, is down sloping.
155
 Figure 1
Value of marginal product curve
(data from table 2)

200

160

120

80

40

2 4 6 8 10

Because the value of marginal product curve is down sloping, as

more of a variable input is used with other factors fixed, the
smaller will be the value of the marginal product.

Another way to visualize value of marginal product is to

place the price of the input, wage, in our example, on the vertical
156
(price) axis and the units of labor on the horizontal axis.
Therefore the value of marginal product is the demand curve for
labor.

By now you are probably asking why economist are so

concerned with table and graphs describing the value of
marginal product. After all it only makes good business sense
that revenues should exceed costs in the effort to maximize
profits.

Cost of the firm – Cost of Production Economic Cost

Total Fixed Cost (TFC) are those costs that do not

change as output increases. It is also known as overhead or
unavoidable cost. The expenses or payments for fixed inputs
are fixed costs.

These costs are largely beyond the business executives’

control, especially those incurred in the short run, and thus must
be paid regardless of output.

Total Variable Cost (TVC) are those costs which

business can control in the short run by changing levels of
production. These are costs that vary directly as output
changes.

If a worker were a variable input of production. Wage and

salary would be the variable costs.

Total Cost (TC) the sum of Total Fixed Cost and Total
Variable Costs at each level of output… It is the sum total of
cost of production which include payments, wage and salary for
labor, rent for land, building and etc., interest for capital and
normal profit for the entrepreneur.

157
OTHER COSTS

Average Fixed Cost (AFC) defined as total fixed cost

divided by output or quantity.

Average Variable Cost (AVC) defined as total variable

cost divided by output or quantity. AVC declines initially,
reaches a minimum and then increase again.

Average Total Cost (ATC) defined as total cost divided

by output. They have to divide total cost by quantity in order to
get the cost per unit.

Marginal Cost (MC) is the extra or additional cost of

producing one more unit of output. MC can be attained for each
additional unit of output by change in output or quantity.

Implicit Cost (IC) the cost of self-generated resources. A

non-expenditure cost. The factors used in production belong to
the users.

Explicit Cost the payment for non-owners of the firms.

An expenditure cost.

The total cost of any output is obtained by adding TFC

and TVC. As you can see in the Figure 7c, Total Variable Cost
(TVC) vary with the output while Total Fixed Cost (TFC) remains
constant as output increased. In short TFC is independent with
the output.

Table and Average Cost Schedule

of the Firm In a Short Run

Total Product Total fixed Total Variable Total Cost

Cost (TFC) Cost (TVC) (TC)

Always Given Always Given Note: if TVC TC=TFC+TVC

is not given
the formula is
158
 TVC=TC-TFC

Avarage Fixed Average Average Total Marginal Cost

Cost (AFC) Variable Cost Cost (ATC) (MC)
(AVC)

AFC=TFC/Qty AVC=TVC/Qty ATC=TC/Qty MC= ∆TC/∆Q

Where :
∆TC=TC2-TC1
∆Q =Q2-Q1

TP TFC TVC TC AFC AVC ATC MC

0 3 0 3 - - - -
1 3 8 11 3 8 11 8
2 3 14 17 1.5 7 8.5 6
3 3 21 24 1 7 8 7
4 3 32 35 .75 8 8.75 11
5 50 3 45 48 .6 9 9.6 13

45

40
Price
35
TC
30 TVC

25

20

15

10

5
159

1 2 3 4 5 6
 MC
ATC
AVC

AFC

Quantity

160
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 6.1

Complete the production cost table

TP TFC TVC TC AFC AVC ATC MC

0 750 1000
1 750 1100
2 750 1180
3 750 1240
4 750 1320
5 750 1420
6 750 1540
7 750 1680
8 750 1840
9 750 2020
10 750 2220

161
162
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 6.2

Plot the production cost table in exercise 6.1

Required: plot MC, ATC, AVC, AFC

163
164
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 6.3

A. Economic Analysis of Costs

In the blanks below, put V if you think the item would contribute
to variable cost and F if you think it would be part of fixed cost in
the short run.

___1. The cost of purchasing raw materials.

___2.Depreciation on machinery when the rate of

production is considered to be the primary source of
depreciation.

___3. The animals fire-insurance premium on plant buildings.

___4. A tax levied on the firm for each hour of labor employed.

___5. Depreciation on the machinery when time rather than

quantity of output produced is considered to be the factor
principally responsible for the depreciation.
165
___6. Salaries paid to supervisors on an annual basis.

___7. Local property taxes on buildings.

___8. The cost of purchasing electric power to run the machines.

___9 The cost of maintaining an active research-and-

development.
___10. A royalty paid for the use of certain machines according
to number of units produced.

166
Chapter 7 INTRODUCTION TO MICROECONOMICS

PURE COMPETITION

MARKETS AND MARKET STRUCTURE

In a market economy there are a large number and many

different types of markets. In many markets-wheat and retail
clothing, for example-there are many firms. In a few markets-
local telephone service and distribution of electricity-there is only
one producer. In some markets-national televisions networks,
soft drinks, and breakfast cereals-there are only a few large
firms. Firms in some markets-wheat, oil, or steel-produce
virtually identical products. In other markets-education, clothing,
restaurants-products come in many varieties. In fact, real-world
markets are far more numerous and complex than we can
possibly describe in detail in this textbook.

Almost every market has some unique element. However,

for analytical purposes, economists generally classify an
167
industry’s market structure as one of the following: (1) pure
competition; (2) monopoly; (3) monopolistic competition; or (4)
oligopoly. When classifying an industry, economists ask three
questions about its fundamental characteristics. How many firms
are in the industry? How much alike are their products? How
easy is it for firms to enter and exit the industry?

As you will learn in this chapter and the remaining

Chapters, market structure affects behavior of firms. By
analyzing the characteristics of markets, economists can answer
the following questions: Why did prices of video recorders and
compact disc drop rapidly in recent years? Why did oil prices rise
in the 1990s and fall in the 2000s? Why do airlines charge
different customers widely varying prices?
COMPETITION AND COMPETITIVE MARKETS

Consider the statement: “There are only three firms in my

industry, and believe me, competition’s fierce.” Implicit in this
statement is the idea of competition as rivalry, or what we call
competitive behavior. Competitive behavior can take a number of
forms-such as advertising, technological innovation, and price
cutting-any of which may give a firm a competitive edge over its
rivals. Nearly every firm engages in some competitive behavior.

Competitive Behavior and the Model of Pure Competition

Economists also use the term competition in a narrower

sense to refer to the pure competition model-a market with the
following characteristics:

1. A large number of producers and consumers, each

acting independently, and each too small to have
any noticeable influence on supply and demand.

2. All the firms in the industry produce virtually

identical goods or services.

168
 3. Both consumers and producers are well informed
about available alternatives and prices.

4. Entry and exit into the industry are unrestricted.

In the real world, however, only a few markets-the stock

market and the markets for wheat and certain other agricultural
commodities, for example-actually have these characteristics.
Why, then, did economists come up with a model of pure
competition? Keep in mind that an economic model is not
necessarily an accurate description of a real-world situation.
Rather, it is a way of predicting economic behavior. And, as you
will see, the model of pure competition can be used to predict
behavior of firms in industries that do not have all the
characteristics of that model.

In this chapter and the remaining chapters, we consider

several different models of markets. We begin with the model of
pure competition because it is a simple. It excludes most real-
world complications and thus is easier to study than more
complicated models. Moreover, the results predicted by the
model of pure competition provide a standard against which to
compare real-world industries. If the purely competitive model is,
in some important sense, ideal, then the closer a real-world
market compares, the better it is.

Pure Competition and Price Takers

To give you an intuitive feeling for the purely competitive

market, let’s suppose that you want to sell 100 shares of Meralco
A stock on the Philippine Stock Exchange. You had hoped to sell
these shares for P40 each, but your broker informs you that the
stock is currently selling for P25 per share. No buyer will pay
P40, or anything more than the current market price of P25. As
one of a very large number of relatively small sellers, your
choices are quite limited: You may sell at the going market price
or not at all.

169
 This example illustrates a basic point about behavior in a
purely competitive market: No individual seller (or buyer) has any
market power, that is, influence on the market price. Because a
firm in competitive market lacks market power, it is called a price
taker. Unless the government imposes a ceiling or support price,
the firm is theoretically free to charge any price for its product.
But realistically, a firm selling in a purely competitive market can
sell all it wants to at the going market price or below, but nothing
above the market price. Like an individual selling stock, the price
taker has two options with respect to price: Take it or leave it.

Profit Maximization in short run: Total Approach

Example:
Perhaps the closest we have ever come to perfect
competition is in the market for such agriculture commodities as
rice corn and cotton. There, we may have a large number of
producer each too small to affect commodity price. The output of
each farmer (rice of given grade) is identical and it is rather easy
to or enter or leave this industry. The perfectly competitive model
is used to analyze markets, such as these, that approximate
perfect competition. It is also used to evaluate the efficiency of
the other forms of market organization.

Whereas:
Q - quantity
P - price
TR - Total Revenue
TC - Total Cost
TP - Total Profits
Formula:
TR - Quantity X Price
170
 TC - Fixed Cost + Variable Cost
TP - Total Revenue – Total Cost

Table 1
Q P TR TC TP
0 8 0 8 -8
1 8 8 20 -12
2 8 16 23 -7
3 8 24 24 0
4 8 32 25.4 +6.60
5 8 40 28 +12
6 8 48 32 +16
6.5 8 52 35.10 +16.90
7 8 56 40 +16
8 8 64 64 0
Figure 1

TC TR

64 B
56
48
Maximum
40 total profit
32
A
24
16
8

1 2 3 4 5 6 7 8
6.5

Profit Maximization in the short run: Marginal Approach

In generalf, it is more useful to analyze the short-run

behavior of the firm by using the marginal revenue-marginal-cost
approach. Marginal Revenue (MR)is the change in TR per unit
171
change in the quantity sol. Since the perfectly competitive firm
can sell any quantity of the commodity at the prevailing price, its
MR=P, and the demand curve it faces is horizontal at that price.
The perfectly competitive firm maximizes its short-run total profits
at the output at which MR or P equals MC(and MC is rising)

Whereas:
Q - quantity
P - Price
TR - Total Revenue
MR - Marginal Revenue
TVC - Total Variable Cost
TC - Total Cost

MC - Marginal Cost
AVC - Average Variable Cost
AC - Average Cost

Formula:

TR = QXP

MR = ΔTR = TR2 - TR1

---------
Δ Q = Q 2 - Q1

TVC = TC – TFC

TC = TFC + TVC

MC = Δ TVC = TVC2 – TVC1

---------
ΔQ = Q2 – Q 1

AVC = TVC
172
 -------
Q

AC = TC
----
Q

Figure 2

16
14 MC
12 AC
10
H
8 d = MR

5.40
6
G
4
2

1 2 3 4 5 6 7 8
6.5

Short – Run profit or Loss

173
 If, at the point where MR = P =rising MC, P exceeds AC,
the firm is maximizing its total profits. If P = AC, the firm is
breaking even. If P is larger than AVC but smaller than AC, the
firm minimizes total losses. If P smaller than AVC, the firm
minimizes its total losses by shutting down. Thus, P = AVC is the
shut down point for the firm. (figure 3)

Example:

The AVC curve and the three alternative demand and MR

curves that the firm might face are shown with the MC and AC
curves. With d3 , the firm produces at C and Q = 6.5, profit per
unit equals P2.60 and total profits = P16.90. With d 2 , the firm
produces at J and breaks even (since P = AC). With d 1, P = AVC
(point T) and the firm incurs a loss per unit equal to it AFC and a
total loss equal to its TFC, whether it produces or not. Thus, T is
the shut-down point. Below P = P4, the firm minimizes its total
losses (equal to its TFC) by shutting down. Between the prices of
P4 and P5.33, P exceeds AVC so that the firm is also covering
part of its AFC. In this case, the firm minimizes its total losses by
staying in business. MC
8 C D3 = MR3
AC
AVC
6 F
5.33 D2 = MR2
Figure 3 J
4 D1 = MR1
T

2
174

1 2 3 4 5 6 7 8 9
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 7.1

Multiple Choice

1. In perfect competition,
a. There are a large number of independent
sellers, each too small to affect the commodity
price
b. The product of all firms is homogenous or
identical
c. Firms can easily enter or leave the industry
d. All of the above

2. A firm maximizes its total profits when

a. TR=TC
b. TC exceeds TR by the greatest amount
c. TR exceeds TC by the greatest amount
175
 d. it is at the break-even point

3. The demand curve faced by a perfectly competitive firm is

a. negatively sloped
b. positively sloped
c. horizontal
d. any of the above

4. MR for the perfectly competitive firm

a. is equal to the change in TR per unit change in
quantity sold
b. equals P
c. is constant
d. all of the above

5. In the marginal approach, the best level of output for a

perfectly competitive firm is the output at which
a. MR or P= rising MC
b. MR or P= falling MC
c. AC is lowest
d. AVC is lowest

6. If at the output at which MC or P= rising MC, P=AC, the firm is

a. making a profit
b. breaking even
c. minimizing losses
d. at its shut-down point

7. If at the best level of output, P is smaller than AC but higher

than AVC, the firm
a. shuts down
b. breaks even
c. minimizes total losses
d. maximizes total profits

8. If at the best level of output, P is smaller than AC but higher

than AVC, the firm
a. incurs total losses
b. greater than its TFC
176
 c. incurs total losses smaller than its TFC
d. makes a profit

9. The shut-down point for the firm is the output of lowest

a. AC
b. AVC
c. MC
d. P

10. The competitive firm’s short-run supply curve is the rising

portion of the
a. MC curve above AVC
b. MC curve above AC
c. AC curve above AVC
d. AVC curve above MC
11. A perfectly competitive firm in long-run equilibrium produces
the output at which
a. P= lowest SAC
b. P= lowest LAC
c. P= SMC
d. All of the above

12. If factor prices rise as industry output expands in the long-

run, we have
a. a constant-cost industry
b. a decreasing-cost industry
c. an increasing-cost industry
d. any of the above

177
178
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 7.2

Review Question

Does perfect competition exist in the real world?

Why do we study the perfectly competitive model?

179
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 7.3

Problem:

A car manufacturer may regard his business as highly

competitive because he is keenly aware of his rivalry with the
view few other car manufacturer in the market. Each car
manufacturers in the undertakes vigorous advertising campaigns
seeking to convince potential buyers of the superior quality and
better style of his automobiles and reacts very quickly to claims
of superiority of his rivals. Is the meaning of perfect competition
from the economist’s point of view? Explain.

180
181
Chapter 8 INTRODUCTION TO MICROECONOMICS

MONOPOLY

Any market structure that does not meet the conditions of

pure competition is an example of imperfect competition. In
this chapter we will explore how firm operates under condition of
imperfect competition.

Definition of monopoly

Monopoly as a condition which exist when there is a

single control over all the supply of a product, thus the permitting
the release of the supply at the rate as will yield the most
profitable price.

Characteristic of Monopoly

 There is a single firm selling the commodity

 There are no close substitutes for the commodity
 The monopolist makes the price
182
  Entry into the industry is very difficult or impossible
 There are may be or no non-price competition like
advertising, sales promotion, etc.

The model of pure Monopoly

To study the impact of market power at its strongest,

economists use the model of pure monopoly. As they do for
pure competition, economists define pure monopoly in terms of
its characteristics.

 There is a single seller in the market.

 The monopolist produces a product with no close
substitutes.
 Entry into and exit from the industry are very restricted.

These characteristics have two important implications.

First, because a monopolists is the only seller of a product that
has no close substitutes, the firm does not have to fear being
undercut in price and losing customers. Second, because entry
is restricted, the monopolists can make decisions without being
concerned that other firms will enter the market, even in the long
run. In effect, the monopolists does not feel the pressures of
competition. The characteristics of pure competition and pure
monopoly are contrasted in

As with the model of pure competition, few, of any

Real-world industries perfectly match all the characteristic of
pure competition. However, the model of pure monopoly can
help us predict the behavior of many firms and industries that are
not monopolies but have significant market power. Examples
include IBM in the early days of the computer industry, General
Motors in its heyday, and the collective market power of OPEC.

Before you can understand how monopolies operate, you

must learn more about their characteristics. What cause entry to
be restricted? What divides close and not so close substitute?
183
Does a monopolist’s unique product allow it to earn economic
profits? These issues are more than academic interest. We
demonstrate what you already suspect: Monopolies that can
exercise substantial market power create problem for a market
economy. These problems have led to legal efforts to control
monopolies. But to address these issues in the real world
requires practical measures of barriers to entry and substitutes.
As you might expect, government efforts to control market power
create great controversy.

Sources of monopoly power

a. natural monopolies

There are a number of industries which by their

technological nature, operate most efficiently if they are
the sole seller of the service. These industries are the
public utilities. It would be inefficient, for example, if a
number of competing companies sought provide
telephone service. The duplication of wires, switching
stations, etc., would be very wasteful.

These industries are closely regulated to protect

the public from the possibility that they would exploit the
monopoly position given them by the government.

B. Government licensing

There are quite a number of other markets in which devices

including government regulations make it difficult for would be
competitors to enter. Physicians, lawyers, dentist, televisions
repairmen, and hair dresser all have to pass examinations before
they can enter their professional activity. Since the most of these
examinations are supervised by groups of people already in the
occupation, the opportunity exist to make the examinations so

184
difficult that they also serve as a barrier to people who provide
too much competition.

C. Cartel

Another source of monopoly power is the cartel. A cartel

is a contractual association formed for the purpose of regulating
the production and marketing of goods by its members. In the
United States, such agreements in restraint of trade normally
considered to violate the anti-trust statutes and hence are illegal.

As you look at the world around you, you can identify

groups that share such monopoly power. The members of
Organization of Petroleum Exporting Countries (OPEC), for
example. Have banded together to control the world price of oil
and therefore raise the price of the gasoline you use in your car.

e. The supply of Chicken

The assumptions we will make about the supply of

chickens is that within a reasonable range of output, they can
produced in the long run under conditions of constant cost. In
terms of supply, we are assuming a horizontal of flat curve. See
figure 1 below

1.20Figure 1
Long Run Supply Schedule for chicken
1.10
1.00
Price.90

.80
.70 S
.60
.50
.40
.30
.20
185
.10
10 20 30 40 50 60
 Millions of kilos
of chickens

Profit Maximization

The profit maximizing or best level of output for the

monopolist is given at the output at which MR = MC. Price is
then read off the demand curve. Depending on the level of AC at
this output, the monopolist can have profits (see Example), break
even or minimize the short-run total losses (see problem and
graph).

Example:

In table 2, the values in columns (1) through (4) com from

Table 1. Columns (2) and (5) give a typical TC schedule. The
other values in this table are derived from the values given in
columns(1), (2), (3) and (5). The MC monopolist maximizes total
profits at P3.75 when it produces and sells 2.5 units of output at
the price of8P5.50. At this output, MR = MC = P3. As long as MR
exceeds MC, the monopolist will expand output and sales
7
because doing so adds more to TR than to TC (and profits rise).
The opposite 6 is true when MR is less than MC (see table 2).
5.5
Thus total 5profits are maximized where MR = MC. The same
conclusion 4can be reached with the “total-revenue-total cost
approach” D
3
2
MR
1 186

2.5
1 2 3 4 5
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 8.1

Please complete the following exercise taking the mini-course on

monopoly.

5. The primary characteristics of a true monopoly is:

e. Control of a large share of the market.

f. Ability to change the price of the product sold.
g. Being the sole seller.
h. Earning a profit.

6. All of the following are sources of monopoly power

which will be sustained in a competitive framework
except:

a. ownership of a patient.
b. Government licensure.
c. Cartel agreements.
d. Superior technology.

187
7. Natural monopolies exist in industries that:

a. mine and market natural resources.

b. Would be inefficient if more than one producer
were operating.
c. Require government licenses to operate.
d. Sell products for which there are no artificial
substitutes.

8. The monopoly will establish that price:

a. which yields highest profit per unit sold.

b. Which is the highest he can charge.
c. At which marginal cost equal marginal revenue.
d. At which total revenue are the largest.

9. Given the following supply and demand graph,

what price will the monopolist charge?

a. P1
b. P2

188
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 8.2

True or False Questions

1. ________ It is generally accepted that the majority of research

and development undertaken by American industries is done by
monopolies.

2. ________ In order to determine the monopolist’s supply curve,

it is necessary to obtain that part of the marginal cost curve
above minimum average total costs.

3. ________ One of the main reasons for the existence of

monopolies is the presence of significant economies of scale so
that output can be produced less expensively when there is only
one firm in an industry.

4. ________ When a monopolist discriminates in price, a

problem that must be solved is how to keep the markets
separate.

189
5. ________ An example of price discrimination is charging
senior citizens less for admission to a theater than is charged for
individuals between 25 and 50 years old.

6. ________ Any time that marginal revenue increases while

marginal costs do not change, the monopolist will decrease
output.

7. ________ Monopoly generates a social cost because it costs

society more to produce an extra unit of output than the value
society places on the extra output.

8. ________ If a monopolist and a competitive industry faced

identical demand and cost conditions, both would produce the
same level of output and charge the same product price.

9. ________ A profit-maximizing monopolist establishes the

optimal output level where MC = MR, and this output is in the
elastic range of the firm’s demand curve.

10. ________ Although it is the usual case for monopoly that PR

> MR, in some circumstances it is possible for MR > P.

11. ________ The profit-maximizing monopolist always attempts

to maximize total revenue.

12. ________ Monopolists do not charge the highest prices that

they could charge.

13. ________ For a monopolist facing a linear demand curve,

total revenue can be increased by reducing price over every
segment of the demand curve.

14. ________ If a monopolist purchases its inputs from a

perfectly competitive input market, the appropriate market
structure in which the producer operates is monopolistic
competition.

190
15. ________ If an industry consists of a dominant firm and a
competitive fringe, the dominant firm may set the price that
maximizes its profits and the competitive fringe will sell that it
wants to at the established price.

16. ________ The demand curve faced by the competitive fringe

in an industry dominated by a single firm is an excess demand
curve.

17. ________ In a monopolistically competitive industry, each

firm has complete control over the market price of its product,
and so other firms do not affect the price at which it sells its
product.
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 8.3

For the monopolist demand schedule of table 1, (a0 find the TR

and (b) graph D and MR.

Table 1

P 12 11 10 9 8 7 6 5 4 3 2 1 0
Q 0 1 2 3 4 5 6 7 8 9 10 11 12

191
Chapter 9 INTRODUCTION TO MICROECONOMICS

OLIGOPOLY

You’ll remember that an oligopoly is an industry

dominated by relatively few firms. They tend to be few because
large amount of capital are required to set up operations. There
are other barriers that help to prevent new firms from entering
these industries; exclusive patents and high marketing cost are
examples.
Other industries that are characterized by oligopoly are
steel, aluminum, petroleum refining, machinery,, typewriters, and
electric light bulbs, to mention only a few. An industry may be
dominated by a handful of firms-aluminum and automobiles – or
there maybe so many firms producing for specialized markets.
In aluminum there are just three large firms. In autos there are
four large firms and a number of foreign firms which sell in the
Philippine market. Petroleum has three very large firms, a
moderate number of medium-sized firms, and a host of small
firms.

192
 Oligopolies formed naturally in the auto and steel
industries. In the beginning, many small firms competed for
market shares. But the heavy costs of initial capital equipment
made unit production costs high. Combining several firms
through merger permitted capital costs to be spread over a larger
combined volume. A merged firm could then undersell its rivals,
drive them out of business, and sometimes by them up at
bargain prices. Eventually, the number of firms was reduced to a
few large of giants. In some industries the process of merging
slowed when public attention was aroused. Now the large firms
tolerate and even encourage the growth of small firms in order to
avoid public pressures to break up the large ones.

Characteristic of Oligopoly

 There are only a few sellers

 There is mutual interdependence among the few
sellers
 There is a rigid price
 Product sold may be homogenous or differentiated.
 There may be a price leader
 There are some barriers t entry into the market
 There is non-price competition

The Kinked- Demand Curve and price rigidity

The kinked-demand curve model seeks to explain the

observed existence of price rigidity or inflexibility in oligopolistic
markets. It postulates that the demand curve facing each
oligopolist has a “kink” or is bent at the prevailing market price.
The demand curve is much more elastic above the kink than
below because other oligopolists will not match price increases
but will match price cuts. As a result, the MR curve has a
discontinuous vertical section directly below the kink. As long as
the MC curve shirts within the vertical section of the MR curve,
the oligopolist keeps his price unchanged or rigid.

193
Example:

The demand curve facing the oligopolist is CEJ and a

“kink” at the prevailing price of P4 per unit and quantity of 200.
Note that demand curve CEJ is much more elastic above the
kink than below, illustrating the assumption that other oligopolists
will not match price increases but will match price cuts. The
corresponding marginal revenue curve is CFGN; CF is the
suggested corresponding to the CE portion of the demand curve;
GN corresponds to the EJ portion of the demand curve. The kink
at point E on the demand curve causes the discontinuity
between F and G in the marginal revenue curve. The
oligopolist’s marginal cost curve can rise or fall anywhere within
the vertical (discontinuous) portion of the MR curve without
inducing the oligopolist to change the sales level and the price of
P4 it charges. Note that again, P exceeds MR where MR = MC,
and so the rising portion of the MC curve above AVC does not
represent the oligopolist’s supply curve.

8
7
6 MC2
5 C MC
E
4
F
3
2 G
d
mr
1
N
0
100 200 300 400 500 600 700 800

194
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 9.1

True or False
(Write T if the answer is true, F if the statement is false)

_____ 1. Oligopolies always have higher profits than more

competitive firms.

_____ 2. In the kinked demand curve model of oligopoly

behavior, for any increase in the cost of production, the model
argues that after careful consideration, producer will more than
likely raise their price.

_____ 3. The avoidance of excessive competition among the

existing firms is essential more the success of oligopolistic
markets.

_____ 4. A firm in monopolistic competition must always take

into consideration the reaction of each competitor when setting
its price.

195
_____ 5. One of the most common forms of collusion among
firms in the United States is to explicitly conspire to set prices.

_____ 6. In a monopolistically competitive industry, the cost of

production could be reduced if the variety of goods on the market
could be limited.

_____ 7. The objective of predatory pricing is called the

existing firms in an industry to cut their prices so severely that
new firms will fail.

_____ 8. If Oligopolists produced a slightly differentiated

product, they would never be in conflict over which price to
charge and which quantity to produce.

_____ 9. In a monopolistically competitive industry, the

product of each firm are unique.

_____ 10. A major reason explaining the failure of cartels is

that some member firms begin to reduce their prices.

_____ 11. If the degree of seller concentration is high in

particular industry, the industry behaves more like a monopoly.

_____ 12. An industry with a four-firm concentration ratio of 46

has more than half its output produced by the four largest firms.

_____ 13. Most of the manufacturing output in the United

States is accounted for by industries with high concentration
ratios.

_____ 14. Although economies of scale are one reason why

an industry may become concentrated, there are equally
important reasons.

_____ 15. In order for an industry to increase its level of

concentration, firms in the industry must be able to explicitly
collude.

196
_____ 16. Many observers of the petroleum market think that
OPEC’s stability during the late 1970’s and early 1980’s resulted
from Saudi Arabia’s role as the dominant firm in the cartel.

_____ 17. When oligopolists do not cooperate and do not

collude, market price will be somewhere between the competitive
price and the monopoly price.

Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 9.2

Word Problem

(a) what does the Kinked demand curve model

accomplish?

(b) what is a cartel? How does it operate?

197
 (c) what is price leadership? How does it operate?

Chapter 10 INTRODUCTION TO MICROECONOMICS

MONOPOLISTIC COMPETITION

Because many firms are competing, each will try to

differentiate its product from the products of others. Many good
examples can be found among retail stores. Often there are real
difference among them-not necessarily in the goods on their
shelves but in the services they provide. No two stores are alike.
They differ in their location or in the other services they provide.
Some store are open longer hours or sell a wider variety of
items. Differences may even be intangible, existing largely in the
mind of the costumer: friendlier clerks, a cleaner store, more
reliable management. A store may appeal to people because
their friends shop there, or those they would like to have as
friends.

If the product differentiation fails-that is, if customers

aren’t convinced that one seller’s product is different from the
another’s- then the industry will be similar to a perfectly
competitive one. All firms will receive the same price for a very
similar if not actually identical product. To the extent that product
198
differentiation succeeds, some firms will be able to get higher
prices than others. Thus convenience food stores can change
more than other grocers; they offer longer hours of operation,
and they operate many small outlets close to people’s homes.

Demand Curves in Monopolistic Competition

Demand curves for firms in monopolistic competition

slope downward. The steepness of the slope demands on the
characteristics of the product. If a product is highly differentiated-
that is, if it appears to consumers to be completely different from
competing products-demand for it will be rather inelastic and the
downward slope will be steep. Demand for the product will
resemble the demand curve of a monopolist, since there are no
close substitutes. A less differentiated product will have obvious
substitutes and so its demand curve will be less steep-more
nearly like a demand curve in perfect competition.
Figure 1 shows a hypothetical demand curve for an
imaginary cola drink, Pepsi-Fizz. For many consumers Pepsi-
Fizz is a beverage that has no substitute. Others will substitute
Coke or Pepsi if they can get it cheaper. The marginal revenue
curve lies below the demand curve to show that each reduction
in price produces a smaller increase in revenue.

Costs in Monopolistic Competition

Costs in monopolistic competition have the same
characteristics as costs in other market structures. Short run
average cost curves are saucer-shaped, and marginal cost
curves rise after some optimum level of production has been
reached. The output that maximizes profit is at the point where
MC=MR. Selling price is determined from the point on the
demand curve directly above MC=MR. Profit average revenue
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and average cost: AR – AC. In figure 1, total profit is the area of
the rectangle whose base is the quantity sold and whose height
is AR – AC.

Long-run equilibrium in Monopolistic Competition

The fact that firms in monopolistic competition with each
other has an important bearing on what happens to them over
time. In the short run a firm may receive economic profit, as
shown by the rectangle in Figure 1. But since the industry is
competitive, this profit, cannot last. Unlike the situation in
monopoly, conditions in monopolistic competition permit free
entry of other firms. ‘The initial capital requirements are relatively
low, encouraging people to set up in business on a small scale.
Technical information is widely available. Even though the
products are similar, there is often room enough in the market for
one or two more firms producing slightly different versions of the
same product.
As new firms enter, the industry moves toward long-run
equilibrium under monopolistic competition. As new firms enter
they take away part of the market from existing firms. Each firm’s
demand curve shifts to the left, eliminating some economic profit.
I8n figure 2 the entry of new firms has reduced each firm’s sales
by half. There is still some economic profit, however, and new
firms continue to enter.
When each firm’s sales have fallen to the position shown
in Figure 3, there is no longer any incentive for new firms to
enter. The industry has reached long-run equilibrium.
What are the characteristics of long-run equilibrium under
monopolistic competition?
(1) At equilibrium, there are no economic profits. There
are only normal profits, which are not great enough to encourage
other firms to enter the industry. There are no losses either,
because firms with losses have withdrawn. Therefore, when
MCMR, average revenue must also equal average cost: AR _
AC = 0. The price is just enough to cover full costs.
(2) Because the demand curve slopes downward, the
average cost curve must also be sloping downward at the point
where AR = AC. That is the only way the two curves can just
touch without crossing each other. This is significant. It means
200
that firms are not producing at their minimum-cost level of output.
If they produced more, AC would be lower. Remember that
under perfect competition, firms are in equilibrium at the lowest
point on the AC curve. To the extent that unit costs under
monopolistic competition are higher than they might be under
competition, the economy is using too many resource to produce
each unit. Consumers are paying a higher price than they would
under perfect competition.

(3) Since each firm is operating at less than the optimum

level, there are too many firms in the industry. The same amount
of output could be supplied by fewer firms. This means that more
capital resources are being allocated to this industry than would
be necessary under perfect competition. The illustration most
often given of this is the highway intersection having three or four
gas stations with several idle pumps. Other examples are the
small stores in every community that seem to have barely
enough customers to stay in business, or two barbers on
opposite sides of the street where one barber wouldn’t be kept
busy full time.
(4) Because their very existence depends on
differentiating themselves from their competitors, firms in
monopolistic competition have to spend money making their
products different from all other products. Bill’s Shoe Shop is an
anxious to acquire loyal customers in order to protect its share of
the market and perhaps expand it. A retailer can appeal to
customers in various ways: through better services, more
accessible shelves, a greater variety of brands, special sales,
and heavier advertising. In other industries the options are fewer.
A manufacturer of electric drills of home carpenters may be
selling a product that is practically identical with those of
competitors. In order to carve out a place in the market this firm
may have to use special merchandising techniques to get its
products displayed so that customers will buy them. It will also
advertise heavily. In terms of our model, all of these methods will
help to shift an individual firm’s demand curve to the right and to
make it steeper.

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Shortcomings of Monopoly Competition
How does monopolistic competition affect us?
Monopolistic competition should be evaluated in terms of
the principles of efficiency and equity. Because monopolistic
competition is similar to monopoly in product uniqueness, it has
some of the same disadvantages as monopoly (refer to the
previous chapter). There are other disadvantages which grow
out of particular features of monopolistically competitive markets.

Characteristics of Monopolistic Competition

 There is relatively large number of sellers

 The product pf each seller is differentiated from
that of all other sellers
 There is a very limited amount of control over the
market price
 There is relatively easy entry into and easy exit
from the market
 There is non-price competition like advertising,
product, promotion, location of the store to prove
that the sellers product is better than the other’s
product

Long Run Efficiency implications of Monopolistic Competition

The monopolistic competitive firm misallocates resources

because where P exceeds MC. It does not, in addition, produce
at the lowest point on its LAC curve as the perfect competitor
does. However, these inefficiencies are usually not great
because of the highly elastic demand faced by monopolistic
competitors.

In contrast to the perfect competitor, the monopolistic

competitor engage in non price competition, which takes the
form of advertising the product differentiation. Such tactics are
intended to increase the firm’s share of the market and shift its
demand curve upward (to the right). However, they also increase
the firm’s cost and shift the firm’s cost curve upward. While some
202
advertising inform the consumer and product differentiation
satisfies the consumer’s desire to variety, both may be excessive
and wasteful. (see figure and 2)

Figure 1

Panel A: Short Run

16
14
12 MC AC

10
8
6
d
4
2 mr

200 400 600 800 1000

Panel B: Long Run

Figure 2
16
14
12 AC
10 MC
8
6
4
2 203 d
mr

200 400 600 800 1000

Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 10.1

Review Question

(a) define monopolistic competition, give a few examples and

identify its competitive and monopolistic elements.

204
Name: ______________________Date : ________________

Section : __________________ Rating : _______________

Exercise No. 10.2

Profit maximization

What is the shape of the demand curve facing a monopolistic

competitor? Why?

How does the monopolistic competitor decide what output to

produce?

205
206
Chapter 11 INTRODUCTION TO MICROECONOMICS

TAXATION and AGRARIAN REFORM

COMPREHENSIVE AGRARIAN REFORM LAW of 1988

Under the CARL (RA 6657), agrarian reform means the

redistribution of land, regardless of crops or fruits produced, to
farmers and regular farm workers who are landless, irrespective
of tenurial arrangement, to include the totality of factors and
support services designed to lift the economic status of the
beneficiaries and all other arrangements alternative to the
physical redistribution of lands, such as production and profit
sharing, labor administration, and the distribution of shares of
stock, which will allow beneficiaries o receive a just share of the
fruits of the lands they work.

The aims of the CARL are the following:

1. To promote social justice by advancing the welfare of the

farmers and farm-workers; and,

207
2. To move the nation toward sound rural development and
industrialization, and the establishment of owner cultivatorship of
economic-size farms as the basis of Philippine agriculture.

COVERAGE

The following lands are covered by the CARL;

1. All alienable and disposable lands of the public domain

devoted to or suitable to agriculture. No reclassification of forest
or mineral lands to agricultural lands shall be under taken after
the approval of this Act until Congress, taking into accounts
ecological, development and equity consideration, shall have
determined by law, the specific limits of the public domain.

2. All lands of the public domain in excess of the specific

limits as determine by congress in the proceeding paragraph;

3. All other lands owned by the Government devoted to or

suitable for agriculture; and,

4. All Private lands devoted to or suitable for agriculture

product raised or that can be raised thereof.

SCHEDULE of IMPLEMENTATION

The distribution of all lands covered by this Act shall be

implemented immediately and completed within ten (10) years
from the effectivity thereof.

RETENTION LIMITS

Except as otherwise provided in this Act, no person may

own or retain, directly or indirectly, any public or private
agricultural land, the size of which shall vary according to factors
governing a viable family-size farm, such as commodity
produced , terrain infrastructure, and soil fertility as determine be
the Presidential Agrarian Reform Council (PRC) created
hereunder, but in no case shall retention by the land owner
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exceed five (5) hectares, three (3) hectares may be awarded to
each child of the landowner, subject to the following
qualifications;

1. That he is at least fifteen (15) years of age

2. that he is actually tilling the land or directly

managing the farm; provided, That landowners whose land have
been covered by PD No. 27 shall be allowed to keep the area
originally retained by them thereunder, further, That original
homestead grantees or direct compulsory heirs who still own the
original homestead at the time of the approval of this Act shall
retain the same areas as long as they continue to cultivate said
homestead.

PRIORITIES

The Department of Agrarian Reform (DAR), in

coordination with the PARC shall plan and program the
acquisition and distribution of all agricultural lands through a
period of ten (10) years from the effectivity of this Act. Lands
shall be acquired and distributed as follows.

Phase One: Rice and Corn lands under Presidential Decree No.
27 all idle lands voluntarily offered by the owners for agrarian
reform; all lands foreclosed by the government financial
institutions all lands acquired by the presidential commission on
Good Government (PCCG); and all other lands owned by the
government devoted to or suitable for agriculture, which shall be
acquired and distributed immediately upon the implementation of
this Act, with the effectivity to be completed within the period of
not more then four(4) years;

Phase Two: All alienable and disposable public agricultural

lands, all arable public agricultural lands under agro-forest,
pasture and agricultural lesses already cultivated and planted to
crops in accordance with Section 6, Article XIII of the constitution
all public agricultural lands which are to be opened for new
development and resettlement and all private and all private
209
agricultural lands in excess of 50 hectares is concerned , to
implement principally the right of farmers and regular farm
markers, who are landless, to own directly or collectively the
lands they till, which shall be distributed immediately upon the
effectivity of this Act, with the implementation to be completed
within the period of not more than (4) years.

Phase Three: All other private agricultural lands commercing

with large landholdings and proceedings to medium and small
landholdings under the following schedules.

a. landholdings above twenty four

(24) hectares up to fifty (50)
hectares, to begin on the fourth
(4th) year from the effectivity of this
Act and to be completed within
three (3) years; and,
b. landholdings from the retention
limit up o twenty four (24) hectares,
to begin on the sixth (6th) year from
the effectivity of this Act and to be
completed within four (4) years: to
implement principally the right of
farmers and regular farmworkers
who are landless, to own directly
collectively the lands they till.

Lands not covered by CARL

Lands actually, directly and exclusively used and

found to be necessary for parks, wild life, forest reserves,
reforestation, fish sanctuaries and breeding grounds, water
sheds and mangroves, national defense, school sites and
campuses including experimental farm stations operated by
public and private schools for educational purposes, seeds and
seedlings research and pilot production centers, church sites and
convents appurtenant thereto, mosque sites and Islamic centers
appurtenant thereto, communal burial grounds and cemeteries,
210
penal colonies and penal farms actually worked by the inmates,
government and private research, quarantine centers and all
land and eighteen percent (18%) slope and over, except all
those already developed shall be exempt from the coverage of
this Act.

Determining of Just Compensation

In determining just compensation, the cost of

acquisition of the land, the current values of like properties, its
nature, actual use and income, the sworn valuation by the
owner, the tax declaration, and the assessment made by the
government assessors shall be considered. The social and
economic benefits contributed by the farmers and farmworkers
and by the government to the property as well as the non
payment of taxes or loans secured from any government
financing institution on the said land shall be considered as
additional factors to determine its valuation.

Valuation and mode of compensation

The Land Bank of the Philippines (LBP) shall compensate

the landowner in such amount as may be agreed upon by the
landowner and DAR and LBP or as may be finally determined by
the court as the just compensation for the land.

The compensation shall be paid in one of the following

terms and conditions;

1. Cash Payment

a. for land above fifty (50) 25% twenty five percent cash,
hectares , in so far as the the balance to be paid in
excess hectares is concerned government financial
instrument negotiable any time

b. Land above twenty four (24) 30% thirty percent cash, the
hectares and up to fifty (50) balance to be paid in
hectares. government financial
211
 instrument negotiable any time.

c. For lands 24 twenty four 35% thirty five percent cash,

hectares and below balance to be paid in
government financial
instruments negotiable at any
time.

2. Shares of stock in government –owned pr

controlled corporations, LBP preferred shares, physical assets or
other qualified investments in accordance with guidelines set by
the PARC (Presidential Agrarian Reform Council)

3. Tax credits which can be used against any tax

liability.

4. LBP bonds

The Beneficiaries

The lands covered by the CARP shall be distributed as

much as possible to landless residents of the same barangay, or
in the absence thereof, landless residents of the same
municipality in the following order of priority:

a. agricultural lessees and share tenants;

b. regular farm workers;

c, seasonal farm workers

d. other farm workers

e. actual tillers or occupants of public lands

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 f. collective or cooperatives of the above
beneficiaries; and

g. others directly working on the land

Provided, however, that the children of land owners who

are qualified under section 6 (retention Limits) of this Act. Shall
be given preferences in the distribution of the land of their
parents; and provided, further, that actual tenant-tillers in the
landholding shall not be ejected or removed there from.
Beneficiaries under Presidential Decree no. 27 who have
culpably sold, disposed of, or abandoned their land are
disqualified to become beneficiaries under this program.
Distribution Limit

No qualified beneficiaries may own more than three (3)

hectares of agricultural land.

Payment by benefits

Lands awarded pursuant to this act shall be paid for by

the beneficiaries to the LBP in thirty (30) annual amortizations or
six percent ( 6%) interest per annum. The payments for the first
three (3) years after the award maybe at reduced amounts as
established by the PARC: Provided, that the first five (5) annual
payments may not be more than five percent (5%) of the value of
the annual gross production as established by DAR. Should the
scheduled annual payments after the fifth year exceed ten
percent (10%) of the annual gross production and the failure to
produce accordingly is not due to the beneficiary’s fault, the LBP
may reduce the interest rate to reduce the principal obligation to
make the repayment affordable.

Transferability of Awarded Lands

Lands acquired by beneficiaries under this Act may not be

sold, transferred or conveyed except through hereditary
succession, or to the LBP, or to the other qualified beneficiaries
for a period of ten (10) years: Provided , however, that the
213
children of the spouse of the transferor shall have a right to
repurchase the land from the government or LBP within a period
of two (2) years. Due notice of the availability of the land shall
be given by the LBP to the Barangay Agrarian Reform
Committee (BARC) of the Barangay where the land is situated.
The Provincial Agrarian Reform Coordinating committee
(PARCCOM), as herein provided, shall, in urn, be given due
notice thereof by the BARC.

If the land has not yet been fully paid by the beneficiary,
the rights to the land may be transferred or conveyed, with prior
approval of the DAR, to any heir of the beneficiary who, as a
condition for such transfer or conveyance shall cultivate the land
himself. Failing compliance herewith, the land shall be
transferred to the LBP which shall give due notice of the
availability of the land in the manner specified in the immediately
preceding paragraph.

In the event of such transfer to the LBP, the latter shall

compensate the beneficiary in one lump sum for the amounts tha
latter has already paid, together with the value of improvement
he has made ob the land.

Creation of Support Service Office

There is hereby created the office of Support Service

under the DAR to be headed by an Undersecretary.

The office shall provide general support and coordinative

services in the implementation of the program, particularly in
carrying out the provision of the following services to farmer
beneficiaries and affected landowners;

1. Irrigation facilities, especially

second crop or dry season irrigation
facilities;
2. Infrastructure development ad
public works projects in areas and
settlements that come under
214
 agrarian reform, and for this
purpose, the preparation of the
physical development plan of such
settlements providing suitable
barangay sites, potable water and
power resources, irrigation systems
and other facilities for a sound
agricultural development plan;
3. Government subsidies for the use
of irrigation facilities ;
4. Price support of guarantee of all
agricultural produce;
5. Extending to small landowners,
farmers and farmers organization
the necessary credit, like
concessional and collateral-free
loans, for agro-industrialization
based on social collateral like the
guarantees of the farmers
organizations.
6. Promoting, developing and
extending financial assistance to
small and medium scale industries
in agrarian reform areas;
7. Assigning sufficient numbers of
agricultural extension workers to
farmers organization;
8. Undertake research, development
and dissemination of information on
agrarian reform and low-cost and
ecologically sound farm inputs and
technologies to minimize reliance
on expensive and imported
agricultural inputs;
9. Development of cooperative
management skills through
intensive training.
10. Assistance in the identification of
ready markets for agricultural
215
 produce and training in other
various aspects of marketing;
11. Administration. Operation,
management and funding of
support service programs and
projects including pilot projects and
models related to agrarian reform
as developed by DAR,
Funding Source

The initial amount need to implement this Act for the the
period of ten (10) years upon approval hereof shall be funded
from the Agrarian Reform Fund created under Section 20 and 21
of Executive Order No. 229.

Additional amounts are hereby authorized to be

appropriated as and when needed to augment the Agrarian
Reform Fund in order to fully implement the provision of this Act.

Sources of funding or appropriations shall include the

following:

1. Proceeds of the sale of Assets Privatization Trust;

2. All receipts from assets recovered and from sales of ill-gotten
wealth recovered through the Presidential Commission on Good
Government;
3. Proceeds of the disposition of the properties of the
government in foreign countries;
4. Portion of amounts accruing to the Philippines from all sources
of official aid grants and concessional financing from all
countries, to be used for specific purposes of financing
production credits, infrastructures and other support services
required by this Act;
5. Other government funds not otherwise appropriated.

All funds appropriated to implement the provision of this

Act shall be considered continuing apprppriations during the
period of its implementation.

216
Financial Intermediary for the CARP

The land Bank of the Philippines shall be the financial

intermediary for the CARP, and shall insure that the social justice
objectives of the CARP shall enjoy a preference among the
priorities.

A Critique

Without the Agrarian Reform a solid industrial base

cannot be developed, for it is the increase in consumption and
investment by the peasant owners that will stimulate higher
demand for industrial products. Agrarian reform, in so far as it
increases agricultural productivity, will also free excess labor
from the countryside for re-employment in industries and expand
the production of raw materials for industrial consumption.

Agrarian reform, however must be differentiated from land

reform as the latter merely refers to the transfer of property
ownership or a reduction in land rent to less onerous levels.
Agrarians reforms in contrast compromise land reform as its
principal component and all the other measures necessary to
ensures the success of land reform. These include making
available to the peasant-owner low-cost credit , cheap fertilizers,
infrastructure and agricultural education among other
necessities.

Agrarian reform, in order to be an effective means of

wealth redistribution , must be no less than a deep and sweeping
reorganization of peasant society the termination of century old
domination of the landlords and socio-economic stagnation and
replacing the structures created by this domination with
structures evolved by the peasants and rural workers to service
their present and emerging concern.

The immediate effect of agrarian reform would be an

increase in the income level of the peasants. This extra income
could either be spent on increased consumption and/or on

217
investments in improving production, either way it would result
in an almost equally immediate increase in productivity.

The increased consumption and/or investment in turn will

induce a demand led growth in rural as well as urban industries
thereby reducing unemployment and stimulating higher demand
for industrial products.

Because farmers would normally consume wage good

that have less import content as compared to the landlords
luxury goods, the transfer of purchasing power would then have
the effect of reducing the import propensity of the economy.
Thus, is so far as it lessens he country’s dependence in import
and stimulates industrialiazation, agrarian reform in itself is an
important aspects of the process of de-internationalizations.

While agrarian reform is the means to end income

inequality, national industrialization is the crucial vehicle for
sustained productivity and growth in the economy.

The measures undertake by the government (Aquino and

Ramos Administration) in relation to land reform are somewhat
limited to completion of Marcos Operation Land Transfer from
tenanted rice and corn lands, reorganizations and streamlining of
the operation of the Department of Agrarian Reform (DAR), and
the formulation of a scheme for foreclosed sugar farms in
Negros. Some big landlords voluntary divest a proportion of their
capital tock, equity or participation in favor of their farmworkers
or other qualified beneficiaries like the members of their families
(e.g. Hacienda Luisita).

There are three aspects of the CARL that call in the

governments resolve.

1. it highlights the issue of tenancy rather than inequity. This is

implicit in its strategy of completing the Operation Land Transfer
on tenanted rice and corn lands but postponing to a later time
areas where there is no problem of share of tenancy that is
under question, that share tenancy is inequitable and other forms
218
of tenurial arrangements are not. Hence, land distribution in
areas not planted to rice and corn may be postponed to a later
date.

2. the government strategy is centered on land reform or

redistribution of land rather than agrarian reform. Completing
Operation Land Transfer without the corresponding adequate
support services such as education, credit, infrastructure,
irrigation etc, only increases risks for the farmer-beneficiaries.
This is in fact was one of the major reasons why the Marcos
Land reform failed in the first place.

3. the government’s proposed financing of the CARL, depends

on the combination of the sale of non-performing assets
(privatization of government owned and confiscated
corporations0 and foreign borrowing because of huge estimate
on land valuation..

4. the Constitution-mandated agrarian reform programme calls

for ‘’just compensation’’, which is interpreted by the government
as ‘’fair market value’’. But paying the landowners fair market
value substantially erodes the very redistributive character of the
program and makes the cost of agrarian reform prohibitive. As it
is, the whole program is dependent on the availability of funds.
Agrarian reform, therefore, creates private wealth while
decreasing the national income , foe every increase in foreign
debt increases the claim of foreign capital over the country’s
resources.

219