lectures and exercises

Principles Of Economics (with Taxation and Agrarian Reform)

Chapter 1

ECONOMICS AND ITS IMPORTANCE

Learning Objectives

1. Understand the nature of Economics and its importance.

2. Know the different fields of study in Economics.

3. Learn the very basic concept and its application through the working of a simple model.

4. Provide example of trade-off among different goods and services.

5. Distinguish the different types of economics systems.

6. Determine the relationship of the different sectors in the economy.

Key terms:

Economics normative economics economics resources

Economic theory efficiency economic system

Economic model descriptive economics market economyVariable equity command economyMarco economics growth stability mixed economy

Microeconomics production possibility opportunity costFrontier

Positive economics scarce resources

Circular flow diagram unlimited wants

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ECONOMICS AND ITS IMPORTANCE

Economics is first and foremost the study of human, behavior in making choices. A household faces many decisions. It must decide who among the households will do such task and what each member gets in return. Who cooks breakfast, who does the laundry, etc. In other words, the household must allocate its scarce resources among its various members taking into account each member’s abilities, efforts and desires.

However, these choices when aggregated explain societal choices in production, consumption, exchange and distribution. Like a household, a society faces many decisions on what jobs will be done and who will do them. It needs some people to grow food, other people to make clothing and others to design computer software. Once the society has managed to allocate its scarce resources, it must also allocate the economy’s output of goods and services that they produce to improve the country’s standard of living.

The management of the society’s resources is important because resources are scarce. Scarcity means that society has less to offer than people wish to have. Just as a household cannot give every member everything he or she wants, a society cannot give every individual the highest standard of living to which he or she might aspire.

Economics is a social science concerned with the efficient allocation and utilization of scarce resources for the satisfaction of the society’s unlimited wants and needs.

In most societies, resources are allocated not by a single central planner but through the combined actions of millions of households and firms. Economists therefore study how people make decisions; how much they work, what they purchase, how much they save out of their income and how they invest their savings. Economists also study how people interact with one another. For instance, they determine how the buyers and sellers of a good together determine the price at which the goods is sold and the quantity that is sold. Lastly, economists analyze forces and trends that affect the whole economy.

Methodology of Economics

The study of economic behavior starts from an economic theory. Economic theory is an attempt to find explanations for observed economic phenomena. Its usefulness aims for the establishment of a cause and effect relationship. It helps us understand why a person makes a certain economic decision or why a particular outcome is realized. A formal statement of an economic theory is called economic model, usually a mathematical statement of a presumed relationship between two or more variables. A variable is a value that can change from time to time or from observation to observation. The most common ways of expressing this are in words, graphs and equations. For example, it the Law of Demand in which graphically the principle could be validated with the derivation of the demand curve and the use of the demand functions.

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There are 2 major divisions of economics: macroeconomics and microeconomics.

Microeconomics is the branch of economics that examines the functioning of the individual industries and the behavior of individual decision making units – that is business firms and households.

Macroeconomics is the branch of economics that examines the economic behavior of aggregate economic variables such as income, output, employment, investment and general level of prices.

Division ofEconomics Production Prices Income Employment

MICROECONOMICS

Production/output in individual industries Ex. How much textile, how many cars

Prices of individual goods and services. Prices of medical care. Ex. Prices of gasoline, rent of apartment, food prices

Distribution of incomes and wealth Ex. Wages in garment industry, minimum wage

Employment by individual businesses and industries. Ex. Jobs in the garment industry, number of employees in a firm.

MACROECONOMICS

National/Production output Ex. Total industry output, GDP/GNP

Aggregate price level, consumer prices, producer prices, inflation rate

National Income Total wages and salaries, Total Corporate Profits

Employment and Unemployment in the economy, Total number of jobs

Table 1.1 Examples of Macroeconomic and Microeconomic Concern

The two kinds of questions that economists attempt to answer: positive and normative.

Positive Economics seeks to understand the behavior and the operation of the economic system without making judgments about whether the outcomes are good or bad. It describes what exists and how it works. Ex. What determines wage rates in the rural areas? What would happen if we abolished the corporate income tax? Answers for these questions are the subject of positive economics.

In contrast, Normative Economics looks at the outcomes of economic behavior and asks if they are good or bad whether they can be made better. It involves judgments and prescriptions for causes of action. Normative economics is often called policy economics. Ex. Should the government subsidizes the cost of higher education?

Positive Economics is divided into two: descriptive economics and economic theory.

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1. Descriptive Economics is simply the collection and presentation of data that describe phenomena and facts. Ex. In the Phil., the National Statistics Office produces an enormous amount of date, as do the NEDA and other non-government agencies.

2. Economic Theory is a statement of a set or sets of related statements about cause and effect, action and reaction. Ex. Law of Demand, which states that as price increases, quantity demanded decreases and vice versa, assuming other factors to be remaining constant.

It helps us understand how the world works, but the formulation of the economic policy requires a second step. It requires us to be specific about the grounds for judging one outcome superior to another.

Criteria for Judging Outcomes.

1. Efficiency. In economics, efficiency means allocative efficiency. An efficient economy is one that produces what people want at the least possible cost. Ex. If the economy allocates resources to the production of things that nobody wants, it is inefficient.

2. Equity. It implies a more equitable distribution of income and wealth.

3. Growth. An increase in the total output of an economy It output grows faster than population, output per capita rises and standard of living increases.

4. Stability. A condition in which national output is steady or growing with low inflation and full employment of resources.

Foundation of Economics

The economizing problem comprises two fundamental facts and provides a foundation for economics.

1. Scarce/limited resources

2. Society’s unlimited wants

Unlimited Wants

What is economic wants? This is the desire of consumers to obtain satisfaction from the various goods and services they consume. It covers a wide range of products from necessities (food, shelter, and clothing) to luxuries (cars, mobile phones, etc.)

Firms and government agencies also strive to satisfy economic goals. To achieve this, they need capital investment and social infrastructures.

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All these wants are unlimited. In other words, individuals and institutions have innumerable unfilled wants. The objective of all economic activity is to fulfill wants.

Scarce Resources

Economic resources refer to all natural, human and manufactured resources that go into the production and services that includes factory, equipments, tools, machinery, transportation and communication facilities, all types of labor, land and mineral services.

Four Categories of Economic Resources

1. Land – it includes all natural resources – all gifts of nature that we used in the production process.

The income received from these resources in rent/rental income. Ex. Arable land, forests, mineral and oil deposits, water resources

2. Labor – refer to all the physical and mental talents of individuals available and usable in producing goods and services. The income realized to those who supply labor is called wages that include salaries and all wage and salary supplements such as bonuses, commissions and royalties.Ex. Teachers, engineers, factory workers, physicians, professional basketball players

3. Capital – includes all produced goods used again to produce consumer goods and services. The income received from using capital is interest income.

Ex. Tools, machinery, equipment.

4. Entrepreneur – an individual who combine land, capital and labor to produced goods or service. The entrepreneurial income is called profits.

Economic System

Every society needs to develop an economic system – which is a set of institutional arrangements and a group of coordinating mechanisms that respond to the economizing problem. Economic system differs as to:

1. Who own the factors of production

2. Method used to coordinate and direct economic activity

The three types of economic system are:

1. Market Economy (Capitalism). There is private ownership of economic resources and the use of market and prices to coordinate and direct economic activity.

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2. Command Economy (Communism). Government owns most property resources and there is central economic planning.

3. Mixed Economy (Socialism). An economic system wherein the basic or key industries are either owned or controlled by the government or by the people collectively.

Economic Model

All models simplify reality in order to improve our understanding of it. The economy consists of millions of people engaged in many activities – buying, selling, manufacturing and so on. To understand how the economy is organized and work, we need a model that would explain it further.

1. Circular Flow Diagram. A visual model of the economy that shows the income received and payments made by each sector of the economy. In this model (2 sector), the economy has two types of decision makers – households and firms. The inner loop of the diagram (Fig. 1)) represents the flow of goods and services using the inputs such as labor, land and capital combined efficiently by the entrepreneur. These inputs are known as the factors of production owned by the household who in return consume all the goods and services produced by the firm.

Households and firms interact in two types of markets. In the product market, households are buyers and firms are sellers. Households buy the goods and services produced by the firm. In the resource market, households are sellers and firms are buyers. Households are the provider of the inputs that firms used to produce goods and services.

The outer loop of the diagram represents the flow of payments or income. The households spend money to buy goods and services from the firm. From the revenue that the firms realized, a part of it will be used to p ay for the payments of inputs such as wages for the workers, rental also member of households. Hence, payment for goods and services flows from the household to firm, and money income in the form of wages, rent and profit flows from firms to households.

Fig. 1.1 The Circular Flow Chart n a Two Sector Model, No Saving Economy

Revenue Expenditures

Goods and Goods and Services Sold Services Bought

Inputs For Labor and

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PRODUCT MARKETFirm Sell, Household Buy

f

FIRMSProduce and Sell

Goods and Services

HOUSEHOLDSPurchase and ConsumeOwn and Sell Inputs of

Production


Production Capital

Wages, Rent, Profit Money Income Fig. 1.2 The Circular Flow Chart in a Two-Sector Model, Saving Economy

Consumption Expenditures(Purchase of Goods and Services)

Output of Goods & Services

Land, Labor, CapitalFactors of Production

(Rent, Wages, Interest, Profits)

Money IncomeInvestment Household

Spending Saving

The savings of the household is a leakage in the circular flow i.e. a saving leakage. Figure 1.2 shows that household savings would not result to a decrease in government spending if it is loaned up to business firms to finance investment. If production depends upon the relationship of revenues of businesses and disbursement of money income, if follows that the value of the output depends upon the households decision to consume and save and the businesses intention to invest.

Fig. 1.3 The Circular Flow in a Three-Sector Model

Consumption Expenditures Output of Goods and Services

Factors of Production

Money Income

Investment household Spending Saving

Taxes

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RESOURCE MARKETHousehold Sell

Firm Buy

f

Businesses Households

Government Businesses Household


The government collects taxes and spends it for different government expenses. Figure 1.3 shows that taxes impose on the value of output decreases the money flow to the household. Tax receipts if not spent, are leakages in the circular flow. The circular flow of money income depends upon the household’s intention to consume, businesses intention to invest and the government’s plan to tax and spend.

Fig. 1.4 The Circular Flow in a Four Sector Model

Exports Gov’t Expenditures

Consumption Expenditutes

Output of Goods and Services

Factors of Production

Money Income

Investment Household Spending Saving

Taxes

Imports

Imports, taxes and savings is a leakage in the circular flow. Imports do not remain in the circular flow therefore it constitutes outflows. Exports and investment spending is an injection. From exports the economy retrieve funds for the circular flow through the receipts of sales from the rest of the world. The circular flow showing this outflows and injections is drawn in Figure 1.4

2. Production Possibility Frontier. A graph that shows the various combination of two commodities that the economy can possibly produce given the available factors of production and available production technology.

Because resources are scarce, a full-employment full production economy cannot have an unlimited output of goods and services. People must choose which goods and services to produce and which to forego. The necessity and consequences of these choices can best be understood through a production possibilities model.

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Rest of the World Gov’t Business Household


Assumptions:

1. Full employment and productive efficiency. Full employment means the economy make use of all its available resources while productive efficiency is production of goods and services in the least costly way.

2. Fixed resources. The available resources are fixed both in quantity and quality.

3. Fixed technology. The methods used to produce output do not change.

4. Two goods.

Table 1.2 Production Possibility Schedule of Clothing and Machinery with Full Employment and Productive Efficiency

Type of Product Production Alternatives

Clothing (in hundred thousand)

Machinery (in thousand)

A B C D E

0 1 2 3 4

10 9 7 4 0

Fig 1.5 The Production Possibility Curve

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Each point on the PPC represents some maximum output of the 2 products. The curve is a production frontier because it shows the limit of attainable output.

At point A, the economy would be devoting all of its resources in the production of machinery while on point E all of its resources would be utilized for clothing production. These two alternatives are unrealistic extremes because an economy typically produces both capital and consumer goods as in B, C, D and E. Moving from alternative A to E, production of clothing increases at the expense of machinery production.

To achieve the various combinations of clothing and machinery that fall on the PPC, the society must achieve both full employment and productive efficiency Point lying inside (to the left, which is pt. G) of the curve are also attainable but they reflect inefficiency. Points inside the curve imply that the economy could have more of both clothing and machinery if it achieved full employment and productive efficiency. Point lying outside (to the right, which is pt. H) represents a greater output. Point H is not attainable given the available supply of resources and technology.

Law of Increasing Opportunity Cost

Because of the scarcity of resources relative to the unlimitedness of human wants, people must choose among alternatives. More clothing would mean less machineries.

The amount of other products that must be foregone to obtain one unit of a specific good is called “opportunity cost”. From alternative A to B, in fig. 1.5, the cost of one unit of clothing is less than one unit of machinery. But considering the cost through the additional production alternatives, B to C, C to D and D to E – the cost foregone for each additional unit

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of clothing is greater than the opportunity cost of the preceding one. For example, from A to B – 1 thousand units of machinery for 1 hundred thousand units of clothing, B to C – 2 thousand units of machinery for 1 hundred thousand more units of clothing, C to D – 3 thousand units of machinery for 1 hundred thousand more units of clothing and D to E – 4 thousand more units of machinery for 1 hundred thousand units of clothing.

Important Points About the Opportunity Cost.

1. In this example, opportunity costs are being measured in real terms rather than in money terms.

2. Marginal (additional) opportunity cost rather than cumulative or total opportunity cost are discussed.

Ex. The marginal opportunity cost of the 2 hundred thousand units of clothing I 3 thousand units of machinery, that is (=10 – 7). The total opportunity costs for the 2 hundred thousand units of clothing is 3 thousand units of machinery (= 1 thousand units of machinery for 1 hundred thousand units of clothing plus 2 thousand units of machinery for another hundred thousand units of clothing).

This example illustrate the Law of Increasing Opportunity Costs which states that the more unit of a product is produced, the greater is the opportunity cost.

Appendix:

Graphs and their meaning

Graphs are most often used to illustrate economic models. It helps an individual visualize and understand economic relationships. Most of the economic principles or models that explain relationships between two sets of economic facts can be conveniently represented with two-dimensional graphs.

Construction of a Graph

A graph is a visual representation of the relationship between tow variables.

Table 1.3 is a hypothetical example that shows the direct relationship between two variables.

Y C Pt.

0 75 A

100 150 B

200 225 C

300 300 D

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400 375 E

500 450 F

Fig. 1.6 shows graphically how consumption changes as income changes. Income as the in dependent variable represents the horizontal axis and consumption as the dependent variable represents the vertical axis as customary.

The vertical and horizontal of the graph is arranged to reflect the range of values of consumption and income and the scales are marked in convenient increment. The values marked on the scales cover all the value in Table 1.3

Each point on the graph represents an income value and its associated consumption value. To plot the point that represents one of the income-consumption combination in Table 1.3 a perpendicular line was drawn from the appropriate values on the vertical and horizontal axes. For example, to plot pt. D (the 300 income – 300 consumption point), perpendiculars were drawn up from the horizontal (income) axis at 300 and across from the vertical (consumption) axis at 300. The perpendicular intersects at point D representing a particular income-consumption combination. A line or smooth curve was drawn to connect all income-combination points. The line represents the income-consumption line showing that the relationship is linear.

Direct and Inverse Relationships

The positively slope line depicts the relationship between income and consumption. A direct relationship implies that two variables change in the same direction. An increase in consumption is associated with an increase in income and vice versa.

In contrast, two sets of data maybe inversely related. Table 1.4 and Fig. 1.7 shows the relationship between the price of pizza and quantity purchased at a pizza chain. The figure shows an inverse relationship because two variables change in opposite directions. When pizza price increases, the quantity purchased decrease and vice versa. The seven data points in Table 4 are plotted in Figure 1.7.

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Table 1.4 The Relationship Between Pizza Prices and Quantity Purchased

Pizza Price Quantity Purchased Pt.

100 0 A

85 3 B

70 6 C

55 9 D

Fig. 1.7

Dependent and Independent Variables

The independent variable is the cause or source and the one that changes first. The dependent variable is the effect in outcome and it changes because of the change in the independent variable. In the income consumption example, income is the independent while consumption is the dependent. Similarly, in example 2, the quantity of pizza purchased is the dependent variable.

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In mathematics, mathematicians always put the independent variable on the horizontal axis and the dependent variable on the vertical axis. Economist way of graphing the dependent and independent variable is more arbitrary. Their graphical presentation of income-consumption relationship is consistent with mathematical presentation but with respect to price and cost data they put it on the vertical axis. Hence, graphing price and quantity purchased data conflicts with normal mathematical procedure.

Other Things Equal

When economists plot the relationship between any two variables the ceteris paribus (other things equal) assumption is employed.

Thus, in Fig. 1.6, all factors other than income that might affect consumption are presumed to be constant. Similarly, in Fig. 1.7, all factors other than pizza price that might affect quantity purchased are assumed unchanged.

In reality, other things are not equal. They often change and when they change, the relationship presented in the two tables and graphs will change and the lines plotted on the graph will shift to new locations.

Slope of a Line

Lines are described in terms of their slopes. The slope of the straight line is the ratio of the vertical (Y axis) change to the horizontal change (X axis) change between any two points of the line.

Positive Slope:

Between pt. C to D in gif. 1.6, the vertical change is P75 and the horizontal change is P100, therefore:

Slope =

Vertical change

horizontal change

75

100

.75

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The slope of .75 is positive because consumption and income change in the same direction.

Negative Slope

Between any two of the identified points in Fig. 1.7 say point B to C, the vertical change is – 15 and the horizontal change is 3. Therefore: -15 Slope = 3

= -.5

The slope is negative because the pizza price and quantity purchased have an inverse relationship. The slope of -.5 means that lowering the price by 15 will increase quantity purchased by 3.

Infinite and Zero Slopes

Many variables are unrelated or independent of one another. For ex. The quantity of mobile phones purchased is not related to the price of mangoes. Fig. 1.8 (a) represents the price of mangoes on the vertical axis and the quantity of mobile phones on the horizontal axis. The relationship is represented by a line parallel to the vertical axis implying that the same quantity of mobile phones is purchased no matter what is the price of mangoes. The slope of the line is infinite.

Fig. 1.8

Price of InfiniteMango Zero

Annulment Rate

(a) (b)

Similarly, total consumption is completely unrelated to the nation’s annulment rate. The line parallel to the horizontal axis represents lack of unrelatedness that shows a zero slope (Fig. 1.8 (b)).

Vertical Intercept

Without plotting the points, a line can be located on the graph if we know its slope and vertical intercept.

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Quantity ofMobile Phone

c


The vertical intercept of a line is the point where the line meets the vertical axis. In Fig. 1.6, the vertical intercept is P75, which means that if the current income is zero, consumers would still spend P75 and they could do this through borrowing or selling some of their assets. In Fig. 1.7 P100 is the vertical intercept, which shows that at the price of P100 no pizza would be purchased because of its higher price.

Equation of a Linear Relationship

In its general form, the equation of a straight line is:

Y = a + bX

Where: Y = dependent variable

a = vertical intercept

b = slope the line

X = independent variable

From the income-consumption example in Table 1.3, if C represent Consumption (the dependent variable) and Y represents income (independent variable), the equation will be written as C = a + bY. By .75Y. This equation would allow us to determine the amount of consumption for every level of income. In figure 2, if P represents the independent variable and Q represents thee dependent variable, their relationship is given by:

P = 100 – 5Q

Where the vertical intercept is 100 and the negative slope is -5.

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Name:________________________________________________ Score __________Section ________________ Room: _________________________Date: __________

Exercise 1.1TRUE OR FALSE.

_________ 1. In the circular flow diagram, households receive income through the product market.

__________2. The resource market is where household buy goods, services, and businesses sell goods and services.

__________3. The price of a new mobile phone can be determined in the product market.

__________4. In the circular flow diagram, household spends income in the resource market.

__________5. Money is considered as a capital resource in economics.

__________6. Failure of the economy to achieve productive efficiency causes an economy to operate at a point inside its PPC.

__________7. All points on the PPC represent productive efficiency.

__________8. PPC is bowed out from the point of origin because it reflects the law of increasing opportunity cost.

__________9. Economic efficiency embodies full employment and full production.

__________10. In the circular flow diagram 2 sector model, businesses are on the buying side of the product market and selling side of the resource market.

__________11. Households are on the selling side of the resource market and buying side of the product market.

__________12. Economics is grounded on two basic facts: limited wants and unlimited resources.

__________13. A workers salary could be determined in the product market.

__________14. Descriptive economics is designed to identify and solve problems to the greatest extent possible and at the least possible cost.

__________15. Normative economics express value judgment.

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Name: _________________________________________________ Score_________________Section___________ _____________Room: ___________________ Date: _________________

Exercise 1.2

A. Indicate which of the following statement applies to microeconomics or macroeconomics.

1. Unemployment rate of the Phil. For the 2nd quarter of 2004 is 13.7%

2. Total exports as of June 2004 is $3.313B and total imports are $3.28B.

3. Consumer Price Index rose by 3%

4. ABC Corporation laid off 5% of their employees.

5. Commercial Banks raise its interest rate on industrial loans by 2.5%

6. A 12% decline in the production output in the garment industry.

7. Minimum wage in Metro Manila area is P285.00 daily.

8. Increase in prices of food products in the market.

9. Gross Domestic Product rise by 5.2%

10. Laborers demand for a 40% increase in daily wage.

B. Identify each of the following statement either as positive or normative.

1. The unemployment rate of the Phil. As of April 2004 is 18.5%

2. Inflation reduces the purchasing power of an individual.

3. Educational institutions must re-engineer their curriculum to be responsive to the needs of the industry.

4. The government is in fiscal crisis.

5. Lawmakers should formulate sound economic policies.

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Name: _________________________________________________ Score_________________Section________________________Room: ___________________ Date: _________________

Exercise 1.3

A. Given below is a hypothetical production possibility schedule of an economy producing only two goods, food and automobile. It shows the various combinations of food and automobile that the economy can produce in a given period.

Production Alternative Unit of Food(in hundred thousand)

Unit of Automobile(in thousand)

A 0 15

B 1 13

C 2 10

D 3 5

E 4 0

Q. Graph the economy’s production possibility curve

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B. Fill in the blanks or choose the correct alternatives.

1. The numbers in the production possibility schedule stand for the (physical quantities, money values) of food and automobile.

2. The numbers represent the (maximum, minimum) amounts of food and automobile that the economy can produce with its available resources.

3. If all of the resources were devoted to food production, _____ units of clothing and _______units of automobile will be produced.

4. If the economy wishes to produced thirteen thousand units of automobile, _____ units of food will be produced.

5. If the economy decreases the production of automobile from thirteen to ten thousand, food production will be increased by ____ units.

6. If the economy increases production of food from one to two thousand, automobile production decreases by _____ units.

7. If economy (can, cannot) produces thirteen thousand of automobile and two hundred thousand units of food because such combination is (within, beyond) the available resources of the economy.

8. The economy (would, would not) produce the ten thousand units of automobile and two hundred thousand units of food because such a combination means that the economy (is, is no t) maximizing the resources.

C. A technological innovation makes it possible to increase production of automobile by 5%.

Construct a new production possibility schedule.

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Name: _________________________________________________ Score_________________Section________________________Room: ___________________ Date: _________________

Exercise 1.4

A. Provide examples of each type of economic system. Classify the Philippines according to the type of economic system and explain your answer.

B. Complete the statements below by matching them with the correct terms.

Competition

Each person

Freedom of exchange

Profits

Self interest

1. In a pure market economy, ______________makes basic economic decisions

2. Market system economy, _________________of buyers and sellers

3. In a market economy, ____________________allows only the most efficient producers to succeed.

4. Producers in a market economy seeks ______________

In a market economy, people buying and selling material goods and one another’s skills have ______________

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DEMAND AND SUPPLY: MARKET EQUILIBRIUM

Learning Objectives

1. Get a good understanding of the meaning of demand and supply.

2. Derive demand and supply schedule and curves with the application of demand and supply model.

3. Identify application of supply and demand and use them for analysis.

4. Examine what determines the demand and supply of goods in a competitive market.

5. Understand how supply and demand together set the price of a good and quantity sold.

Key terms:

Demand complementary goods change in quantity supplied

Quantity demanded equilibrium price equilibrium quantity

Income effect law of demand surplus

Substitution effect law of supply shortage

Primary demand individual supply change in quantity demanded

Individual demand market supply

Market demand

Substitute goods

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Chapter 2

DEMAND AND SUPPLY: MARKET EQUILIBRIUM

Resources are scarce and human wants are insatiable. These two facts are the foundation or root problems of economics. How to maximize consumer satisfaction depends on the efficient management of these limited resources. So, the decision of choices about what and how much goods, comes to fore. All consumers want quality life. What goods and services do we consumers desire? Having a nice house to live in, a nice cloth to wear, good education, having one’s own car and so forth are all-important. But what determines what goods and services the consumer’s want? How do consumers decide what to buy? The following sections will help you understand the demand and how the consumers fulfill their demand for goods and services based on their needs, income, prices and ll possible available alternatives.

Demand and Prices

The buyers want the price that will give them the most value for the least cost. Assuming all things are equal, with a given income, the buyer will tend to buy more units of an item at lower prices or less units at higher prices.

What demand? Demand is a schedule of the different quantities of a good that the buyers are willing and able to buy at different prices at a given time. For example, a buyer has P6 to spend for product X. the schedule below shows the different quantities of X the buyer is willing and able to buy corresponds to given set of prices in the market.

Demand for Product X

Price Quantity demanded

P 0.10 60 units

0.20 30 units

0.30 20 units

0.40 15 units

Table 2.1

At price P0.10 the quantity demanded is 60 units. At price P0.40 the quantity demanded is 15 units. The term, quantity demanded is the amount of good that the buyers

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are willing and able to buy at some particular price. The specific quantity of 60 units that will be bought at a specific price of P0.10 is quantity demanded. For demand to be effective, buyers must be willing and able to buy the goods.

Law of Demand

The law of demand indicates that as price increases, a smaller quantity will be bought as price decreases, a larger quantity will be bought. It indicates an inverse relationship between price and quantity demanded.

The law of demand can also be explained in terms of income and substitution effect.

1. Income effect means that a decrease in the price of a product will increase the purchasing power on one’s money income; hence, you are able to buy more of the product than before. For example, the buyer has P20, at price P5 per unit, he can buy 4 units of the product. If the price goes down to P2 per unit, he can n ow buy 10 units instead of 4 units.

2. Substitution effect indicates that, at a lower price, one has the incentive to substitute the cheaper good for similar goods, which are now relatively more expensive. For example, at a lower price, beef is relatively more attractive and it is substituted for pork.

The income and substitution effects combine to make consumers able and willing to buy more of a product at a low price than at a high price.

Demand curve is a graphically illustration or representation of demand.

The curve slopes downward from left to right.

Figure 2.1

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Types of Demand

A. Primary demand or Consumer demand

1. Individual demand

2. Market demand or collective demand

B. Derived demand or producer demand

Demand for final goods is primary demand or consumer demand while demand for the factors of production is derived demand or producer demand.

Demand for the factors of production like bakers, oven, yeast, flour, and othes depends on the desire and income level of the consumers for the final goods like bread, cakes, pastries and other bakery products.

Individual demand is the demand of an individual consumer for a given commodity. Market demand is the sum total of individual demand. For example, if household A, B and C comprise the entire consuming public. Household A has an income of P10; household B, P6; and household C. P12 for product x.

Table 2.1

Factors affecting Demand (Determinants of Demand)

1. Number of buyers.2. Consumer income.3. Consumers’ tastes and preferences.4. Prices of related goods.5. Consumer expectations with respect to future prices and income.

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Quantity Demand

Household Household Household MarketPrice A B C DemandP0.10 100 60 120 280

0.20 50 30 60 140 0.30 33 20 40 93 0.40 25 15 30 70


1. Numbers of Buyers

There will be an increase in demand if there are more buyers in the market. Fewer buyers will be reflected by a decrease in demand.

2. Consumers’ Income

(a) Superior good or normal good is good which demand increases as consumer income increases.

(b) Inferior good is a good which demand decreases as consumer income increases.

(c) A decrease in consumer income will cause a decline in the demand for a good.

3. Consumers’ Tastes and Preferences

A favorable change in consumers’ tastes and preferences for a product will cause demand to increase. An unfavorable change in consumers’ tastes and preferences will cause demand to decrease.

Demand is also influenced by psychological needs. Recently, bracelets and necklaces made of semi-precious stones and beads are a fad. Most of the women, young and old, wear these fashioned jewelries. Why? Because others wear them, we imitate . Some items,

26

More buyers, Demand will increase

Fewer buyers, Demand will decrease

Increase in income, Demand will decreases.

Decrease in income, Demand will decrease

Increase in income, Demand will increase

Consumers favoring product X, Demand for X will increaseConsumers not favoring X, Demand for X will decrease


which are offensive at one time, may not be offensive at another time because of the changes in fashion and tastes.

4. Prices of Related Goods The related goods are either substitute goods or complementary goods.

5. Substitute Goods ( or competing goods) are goods which are used in place of other goods. For example, butter and margarine. If the price of butter goes up, demand for margarine will increase. If the price of butter goes down, demand will decrease. The price of one good and the demand for the other are directly related.

Butter MargarinePrice Demand will Price Demand will

Complementary goods are goods that go together. For example, car and gasoline. If you buy a car you must buy gasoline. If the price of gasoline up, demand for car will decrease. If the price of gasoline goes down, the demand for car will increase. The price of one good and the demand for the other are inversely related.

Price of Gasoline Demand for car willIncreases DecreaseDecreases Increase

6. Expectations Consumer expectations of higher future prices may prompt them to buy now in order to “beat” the anticipated price rises. Similarly, these expectations of the higher future income may induce the consumers to increase their current spending. On the other hand, consumer expectations of lower future prices and income will cause a decrease in the demand for the good.

Changes in Quantity Demanded

A change in quality demanded is affected by the change in price. It is a movement from one point on a fixed demand curve. For example

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Price/Income in the near Future expected Demand today will

Increase Increase Decrease Decrease


Shift in Demand Curve

A change in demand is affected by one or more of the determinants of demand. “Demand” refers to a schedule or curve; therefore, a change in demand’ must mean that the entire schedule has change and that graphically, the cure has shifted its position. For example

28

Fig. 2.3 (b)


Supply

The job of sellers is to supply what buyers demand. What and how much will be produced and who will produce it are an important question that directly affects us as consumers. What decisions will the sellers make depend on many things. The following sections will help you understand the relationship between supply and price in a market economy.

Supply

Supply is a schedule of the different quantities of goods that the sellers are willing and able to sell at different prices at a given time. For example,

Table 2.3

Supply Schedule of Product X

Price Quantity Supplied

P10 0 Units

20 500 Units

30 1000 Units

40 1500 Units

50 2500 Units

No seller is willing to sell any units of X at P10. When the price is P20, sellers are willing to supply 500 units. At P50 a unit, the sellers are willing to supply 2,500 units. Zero units, 500 units, and 2500 units are quantity supplied.

Quantity supplied is the amount of goods that the sellers are willing and able to sell at some particular price. For supply to be effective, sellers must be willing and able to sell the product.

Law of Supply The supply schedule illustrates the law of supply: as price increases, a larger quantity will be sold; as price decreases, a smaller quantity will be sold. The law of supply indicates a direct relationship between price and quantity supplied.

29


Supply curve is a graphical illustration or representation of supply. The curve slopes upward from left to right. Fig. 2.4

Types of Supply

1. Individual supply is the supply of an individual seller of a given commodity.

2. Market or collective supply is the sum total of individual supply.

Example: Presented below is the supply schedule of product X by firms A, B and C.

Table 2.4

Quantity Supply

Price Form A Form B Form C Market Supply

P 10 10 15 7 32

20 12 20 10 42

30 14 25 13 52

40 16 30 16 62

50 18 35 19 72Factors affecting supply (the determinants of supply)

1. Number of sellers

2. Changes of technology or method f production

3. Changes in the cost of production

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4. Sellers expectations with respect to the future prices. (Price expectations)

1. Number of Sellers

More sellers will increase supply. Fewer sellers will decrease supply.

Number of sellers Supply will

More Increase

Fewer Decrease

2. Change in Technology or method of Production

If a new technology is introduced which makes it less expensive to produce a product, there will be an increase in supply. On the other hand, a more expensive method is used in the production; the change decreases the amount produced at any given price (decrease in supply).

Method of production Supply will

Less Expensive Increase

More Expensive Decrease

3. Change in the Cost of Production

Prices of human, natural and capital resources often change. These changes affect a producer’s ability to supply goods at a certain price. Increasing cost of production decreases supply. Decreasing costs increases supply.

Cost of Production Supply will

Increase Decrease

Decrease Increase4. Expectations

Expectations concerning future prices of a product may affect a producer’s current willingness to supply that product. Expectations of a higher future price will decrease the present supply curve of a product. A fall or decline in price will increase the present supply of a product.

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Present Near Future

Decrease in Supply Increase in Price

Increase in Supply Decrease in Price

Change in Quantity Supplied

Quantity supplied is affected by the change in price. It refers to the movement from one point to another point on a stable supply curve.

Example

Shift in Supply Curve

A change in supply is affected by one or more of the determinants of supply. Like demand, “supply” refers to a schedule or curve; therefore, a “change in supply” must mean that the entire schedule has changed and that graphically the curve has shifted its position. Example,

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Demand and Supply: Market Equilibrium

In a market economy, prices are determined by the interaction of demand and supply, the decision of the buyers to buy and the decisions of the sellers to sell. Buyers will buy more goods at lower prices than at higher ones. Sellers will sell more goods at higher prices than at lower ones. But at a certain point, there is a price, which will be satisfactory to both the buyers and the sellers. Hence, the quantity the buyers are willing to buy will be equal to the quantity of the sellers are willing to offer for sale. There is no surplus or shortage exists. No pressure for the price to change, there is a market equilibrium.

Graphically, the interaction of the demand curve and the supply curve of the product will indicate the equilibrium point. The price and quantity determined by the interaction are the equilibrium price and equilibrium quantity.

Market Demand and Supply of Product X

Table 2.5

Quantity Quantity Surplus Effect on Who bid up/Demanded Price supplied or shortage the prices lower the prices

100 units P10 30 units shortage increase buyers

60 units 20 60 units equilibrium constant -

20 units 30 100 units surplus decrease sellers

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Equilibrium price is the price at which quantity demanded is equal to quality supplied.Equilibrium quantity is the quantity exchanged at equilibrium price and quantities are P20 and 60 units.

A surplus is a situation wherein quantity supplied is greater than demanded. A price P30, there is an excess supply of 80 units. With such large surplus, seller have no choice but to roll back the price toward its equilibrium point.

A shortage is a situation wherein quantity demanded is greater than quantity supplied. At price P10, there is an excesss demand of P70 units. When the price is below the equilibrium price, the sellers may not supply as much of a good or service as consumers want. Competition among the buyers for the goods will bid up to the price.

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Name: Score:Section: Room: Date:

Exercise 2.1

Fill the blanks / underline the best alternative

1. The demand schedule has two columns: and

2. The law of demand indicates a (an) (direct/inverse) relationship between price and quantity demanded.

3. A good which demand decreases as consumer income increases, is calledgood.

4. Demand for product B increases as the price of product A declines. Products A and B are (substitute / complementary) goods.

5. The law of demand states that as price rises buyers will purchase (more/less/zero/the same) quantity of the product.

6. A change in the number of buyers would affect (demand / quantity demanded).

7. A change in the price of the product would affect (demand/quantity demanded).

8. A change in consumer income would affect (demand, quantity demanded).

9. demand is the demand for final goods.

10. demand is sum total of individual demand.

11. Derived demand is the demand for .

12. are goods that are used together.

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Exercise 2.2

Presented below are the demand schedules for rice (in kilogram/month) of three households.

Quantity Demanded By Market Market Market

Price Household A Household B Household C Demand Demand Demand(1) (2) (3) (4) (5) (6) (7)

P35 1 4 4

30 2 6 8

25 3 8 12

20 4 10 16

15 5 12 20

1. Assuming the above three households comprise the entire rice consuming public. Compute the market demand in column (5) above.

2. Plot the market demand curve and label it (a).

3. If the price were P30/kg.

a. How many kilograms would household a wish to buy? Kgs.b. How many kilograms would household B wish to buy? Kgs.c. How many kilograms would household C wish to buy? Kgs?d. How many kilograms would the entire consuming public wish to buy?

Kgs.

4. Household B doubles its purchase of rice. Derive the new market demand schedule in column (6) above.

5. Plot the new market demand curve on the graph in No. 1 and label it (b).

6. If the price were P30/kg.

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a. How many kilograms would household A wish to buy? Kgs.b. How many kilograms would household B wish to buy? Kgs.c. How many kilograms would household C wish to buy? Kgsd. How many kilograms would the entire consuming public wish to buy? Kgs

7. Household A suddenly stops buying rice. Derive the new market demand schedule in column (7) above.

8. Plot the new demand curve on the graph in No. 1 and label it (c).9. If the price were P30/kg.

a. How many kilograms would household A wish to buy? Kgs.b. How many kilograms would household C wish to buy? Kgs.c. How many kilograms would household C wish to buy? Kgs.d. How many kilograms would the entire consuming public wish to buy?

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Name: Score: Section: Room: Date:

Exercise 2.3

Which figure (A) , (B) , (C) or (D) illustrates the effect of each of the following on the demand for product X?

1. An increase in consumer income, assuming product X is an inferior good.

2. A decrease in the number of X buyers.

3. A decrease in the price of product Y, a substitute of product X

4. A change in consumers’ tastes, in favor of product Y, a complement of product X

5. An increase in the price of product X

6. A decrease in the price of product Y, a complement of product X

7. The consumers expect the price of product X to decrease in the near future.

8. A decrease in consumer income.

9. A decrease in the price of product X

10. An increase in the price of product Y, a substitute of product X

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Name: Score: Section: Room: Date:

Exercise 2.4

Identify the following pairs. Write C for complements and S for substitutes.

1. Chicken and turkey

2. Gasoline and motor oil

3. Barbecue charcoal and charcoal lighter fluid

4. Coffee and tea

5. Car and gasoline

6. Ball pen and fountain pen

7. Blouse and skirt

8. Yellow taxicab and red taxicab

9. Blackboard and chalk

10. Yellow pad paper and intermediate pad paper.

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Exercise 2.5

Fill in the blanks / underline the best alternatives.

1. The supply schedule has two columns: and .

2. When more units of a commodity are offered for sale at each price, there has been an increase in (supply, quantity supplied).

3. A movement up (down) along the supply schedule implies a change in (supply, quantity supplied).

4. Which of the following could not cause a change in the supply of commodity X?

a. A decrease in the price of X

b. An increase in population

c. An improvement in the method used in producing X

d. A higher wage rates in X industry

5. The law of supply indicates a (an) (direct, inverse) relationship between price and quantity supplied.

6. A change in the prices of resources would affect (supply, quantity supplied).

7. A change in the price would affect (supply, quantity supplied).

8. An increase in supply would shift the curve to the (left, right).

9. A decrease in supply would shift the curve to the (left, right).

10. Supply is the supply of an individual seller of a given commodity.

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Name: Score:Section: Room: Dare:

Exercise 2.6

Presented below are the schedules of commodity X of 3 individual firms:

Quantity Supplied By:

Price Firm A Firm B Firm C Market Supply Market Supply

(1) (2) (3) (4) (5) (6)

P35 1 4 4

30 2 6 8

25 3 8 12

20 4 10 16

15 5 12 20

A. Compute the market supply (5) above.

B. Plot the market supply curve and label it (a)

C. If the price of X were P30 per unit:

1. How many units of X will all sellers supply? Units

2. How many units will Firm A supply? Units

3. How many units will Firm B supply? Units

4. How many units will Firm C supply? Units

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D. Improvements in the method in producing commodity X by Firm C allow it to supply 5 more units at every price. Compute the new market supply in column (6) above.

E. Plot the new Market supply curve in the graph in (B) and label it (b).

F. If the price of X were P30 per unit:

1. How many units of X will all sellers supply? Units.

2. How many units will Firm A supply? Units

3. How many units will Firm B supply? Units

4. How many units will Firm C supply? Units

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Exercise 2.7

Which figure – (A), (B), (C) or (D) – illustrate the effect of each of the following on the supply of product X?

1. An increase in the number of X producers.

2. An increase in the price of product X

3. A change in technology which reduces the cost of producing X

4. An increase in the wage rates in X industry

5. The producers expect the price of product X to increase in the near future.

6. The government granted a subsidy ofP1.00 per unit of product X produced.

7. The government imposed a tax of P0.50 per unit of product X produced.

8. A decrease in the price of product X

9. The number of firms producing X decreases

10. Firm expect the price of X to decrease in the near future.

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Exercise 2.8

Demand, Supply and Equilibrium

Matching type: Write the corresponding Capital Letter

Terms:

A. Price ceiling H. Change in demandB. Decrease in supply I. Inferior goods

C. Increase in supply J. Normal goods

D. Decrease in quantity demanded K. Equilibrium price

E. Increase in quantity demanded L. Substitute goods

F. Change in quantity demanded M. Complementary goods

G. Shortage N. Surplus

1. A situation that exists below the equilibrium

2. Movement of a point downward demands curve.

3. Shift of the supply curve to the right.

4. Consumers buy more of this good if their income increases.

5. Movement of as point upward or downward a demand curves.

6. The price at which quantity demanded is equal to quantity supplied.

7. An increase in the price of one product causes a decrease in the demand for another product.

8. A situation wherein quantity supplied is greater than quantity demanded.

9. An increase in the income of the consumers causes a decrease in the demand for these goods.

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10. The demand curve shifts either to the left or to the right.Name:_______________________________________ Score______________ Section_________________Room_________________Date_______________

Exercise 2.9

Fill in the blanks. Underline the best alternatives.

Demand SupplyPrice Quantity demanded Price Quantity supplied(P) (X) (P) (X)20 4000 20 100040 3000 40 150060 2000 60 200080 1000 80 2500

1. From the above demand and supply schedules, the equilibrium price and

quantity are P_____ and _____ units.

2. If the price were set at P20, there would be a (surplus/shortage) of good equal to_________units

3. If the price were set at P80, there would be a (surplus/shortage) of good equal to_________units.

4. A surplus exists at P______price level.

5. A shortage exists at P______and P_____price levels.

6. If the price is P40, (buyers/sellers) will (bid up/lower) prices.

7. If the price isP80, (buyers/sellers) will( bid up/lower) prices.

8. If the price isP80, price will tend to (increase/decrease/remain the same).

9. If the price is P20, price will tend to (increase/decrease/remain the same).

10. If the quantity supplied is doubled at each price, level and quantity demanded remains unchanged, the new equilibrium price and quantity will be P______and_______units.

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Name:__________________________________________________Score:_________Section:_______________________Room:_____________________Date:__________

Exercise 2.10

Multiple choice: Write the letter:

1. I f the demand is DD and supply is SS, the equilibrium price and quantity will be

A. P and Q C. P and Q

B. P and Q D. P and Q

2. If demand shifts to DD with no changes in supply (SS), the new equilibrium point will be

A. A C. C

B. B D. E

3. If demand is DD and supply is SS the mew equilibrium price and quantity will be

A. P and Q C. P and Q

B. P and Q D. P and Q

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4. If demand is DD and supply is SS at price P , there will be

A. A shortage of X C. an equilibrium point

B. A surplus of X D. a price ceiling

5. If demand is D D and supply is S S, at price P , there will be

A. A shortage of X C. an equilibrium point

B. A surplus of X D. a price ceiling

6. An increase n demand can be represented as

A. a movement from DD to D D

B. a movement form D D to DD

C. a movement up along DD or D D

D. a movement down along DD or D D

7. An increase in quantity demanded can be represented as

A/B/C/D (see question No.6)

8. An increase in supply can be represented as

A. a movement from SS to S S

B. a movement from S S to SS

C. a movement up along SS or S S

D. a movement down along SS or S S

9. An increase in quantity supplied can be represented as

A/B/C/D (see question No.8)

10. At price P , a movement from point F to point A indicates

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A. An increase in supply

B. A decrease in supply

C. An increase in quantity supplied

D. A decrease in quantity supplied

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Name:_________________________________________________Score:__________

Section:______________Room:_____________________________Date___________

Exercise 2.11

Illustrate graphically the effect of each of the following on the equilibrium price (P) and equilibrium quantity (Q). (The following symbols stand for: D ( demand), S ( supply), (increase), (decrease), - (constant), > (greater than), < (less than), = (equal to)

49


Name:____________________________________________Score:________

Section:___________________Roo:____________________Date:_________

Exercise 2.12

Examine and indicate the effect of each of the following events on the demand for (D), supply of (supply), equilibrium price (P) and equilibrium (Q) of product X.

Answer code: for increase

for decrease

_ for constant

EVENT D P S Q1. Series of studies that X provides many

Nutritional benefits for a healthy body. – –

2. An increase in the price of X –3. An increase in consumer income

assuming X is a normal good. – –

4. A change in technology, which decreases costs of producing X.

– –

5. Both the consumers and the producers expect the price of X to increase in the near future.

– –

6. A decrease in the price of X. 7. A decrease in the price of Y, a substitute

of X.

8. An increase in the prices of raw materialsuse in X production.

–

9. Medical bulletin warned that product XHas high cholesterol and saturated fat content which can lead to gallstones andObesity.

– – –

10. A change in consumers’ tastes, favoring Y, a complement of X.

– –

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NATIONAL INCOME ACCOUNTING

Learning objectives

1. Know the approaches in the computation of GDP, GNP and other national income accounts as well as the purpose of measuring these accounts.

2. Understand related concepts such as nominal and real GDP/GNP, price index and GDP deflator.

3. Determine the types of transaction that are included or excluded from the measurement of GNP.

4. Solve problems and the solution through examples.

5. Explain the problem of double counting and know the approach of summing value-added of final goods.

6. Relate nominal to real interest rate.

Key terms:

Gross national product value added

Final goods net national product

Intermediate goods national income

Real GNP personal income

Consumer price index personal disposable income

Transfer payment personal savings

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CHAPTER 3

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NATIONAL INCOME ACCOUNTING

The executive of a firm wants to know how well firm is performing. What measures should he undertake to improve the financial standing of the firm? Accounting date provide him with the information he needs to assess the operation of the firm. What accounting does to the firm is what it does for the economy as a whole. National income accounts provide the framework of the economy’s performance and the economy’s stage of economic development. Hence policies can be formulated to improve the performance of the economy.

Gross National Product (GNP)

Gross National Product is the market value of all final goods and services produced in the economy during a given period of time, usually one year.

Final Goods are goods which are for final consumption by the end user. While intermediate goods are goods which are to be processed, further into other goods. To avoid counting, only final goods and services are counted as part of GNP. For example, a consumer buys leather, the price paid for leather is counted as part of GNP if it will not be sold again and it is in its final form. However, if a shoemaker uses leather to produce a pair of shoes, leather will be counted as part of that pair of shoes. If both the leather and the shoes were counted, the leather would be added in twice and so exaggerate the GNP.

GNP may increase if there is an increase in (a) the prices, (b) the quantities, or (c) both the prices and the quantities of goods and services produced. To reflect the real output, we adjust the GNP figures by using the consumer price index (CPI) as deflator or inflator. Adjusted or real GNP is the money GNP divide by CPI.

Real GNP =Money GNP C P I

Consumer Price Index (CPI) is a tool used to measure the changes in the prices of the commodities.

CPI = P x 100 P

Where: P = price in a given year P = price in a base year

Items that are not included or reflected in GNP

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1. Quality of the goods and services producedFor example, the computers produced today are very much better and advance than the computers in 1975. GNP only shows the total value of computers produced today is greater than their total value in 1975.

2. Leisure time

GNP does not reflect the improvements in efficiency. The workers today produce more goods and services than the workers did it 40 years ago. Increases in efficiency have allowed people more free time, which is not reflected in GNP.

3. Housewives’ services

The services of a housewife are free and GNP does not count those that are given away free. GNP measures only goods and services that command a price.

4. Resale

GNP counts only new goods produced for sale. Resold or transferred goods are not counted because no wealth is created. Goods produced during a specific year are counted. Those produced before or after are not added into GNP for the year. For example, year 2002 GNP did not include goods produced in year 2001 and those in year 2003.

5. Transfer payments

Gift, grants, retirement and pension payments and others are not included in GNP because they do not affect the production of goods and service.

6. Security

Buying and selling of stocks and bonds do not affect the production of goods or operation of the business. Thus, they are not counted.

Method used to measure GNP

1. Expenditure method or flow of product approach.2. Income method or earnings and cost approach.3. Industrial origin method.4. Value added approach.

1. Expenditure Method or Flow of Production Approach:

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This method measures all the money spent on goods and services by the following sectors:

(a) Personal consumption expenditures (C) Spending of consumers on final goods and services.

(b) Gross private domestic investment (Ig) Spending of business for new capital goods (investment)

(c) Government purchases of goods and services (G)Spending of all levels of government.

(d) Net exports (of goods and services) (Xn)

Net Exports are the value of the goods sold outside the country (exports) less the value of the goods sold in the country that are made abroad (imports).

Xn = Export – Import

GNP = C + Ig + Xn (in the case of an open economy)

GNP = C + Ig + G (in case of a closed economy)

2. Income Method or Earnings and and cost Approach

This method accounts for all the money received for the production of goods and services.

Add: RentsWages and salariesInterestsProprietor’s incomeCorporate incomeIndirect business taxesDepreciation

Equals: GNP

Corporate Income = undistributed Corporate Profits + dividends + Corporate Income Taxes

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Industrial Origin Method

This method measures the value of the goods and services produced by the following industries.

Industry

Add: 1. Agriculture, Fishery and forestry---------------------------- P xxx

2. Industrial Sector------------------------------------------------- P xxx

a. Mining and Quarrying-------------------------------- P xxb. Manufacturing------------------------------------------- P xxc. Electricity, gas and water---------------------------- P xx

3. Service Sector----------------------------------------------------- P xxx

a. Transport, communication-------------------------- P xxand storage

b. Commerce---------------------------------------------- P xxc. Services------------------------------------------------- P xx

Equals: GROSS DOMESTIC PRODUCT (GDP) ----------------- P xxx

Less: Net factor income from the rest of the world-------------- (P xx)

Equals: GROSS NATIONAL PRODUCT (GNP) ---------------- P xxx

Philippines use the industrial origin method to measure GNP.

3. Value Added Method

This method measures the value of the goods and services produced based on the value added at each stage of production or distribution and included in the cost to the ultimate consumer.

55


Value added is the difference between the cost of materials goods and the value of the sales of goods. For example, if a firm buys materials for P100 and produces from a product while sells for P250, the value added by the firm is P150.

Candy Manufacturing

Sales Value ofMaterials/Product Value Added

Farmer (sugar cane) P1000 P1000Miller (sugar) 1500 500Confectionaire (candy) 3000 1500Retailer 5000 2000

P10,500 P5000

The value of the final good (candy) is P5000

Net National Product (NNP)

Net national product is gross national product less capital consumption allowances (depreciation).

NNP = GNP – depreciation

National Income (NI)

National income is the payments of income to the factors of production.

NI = NNP – Indirect business taxes

Personal Income (PI)

Personal income refers to payments of income to individuals such as rents paid to the owner of the land, wages paid to the laborers, and interests paid to the owners of capital.

PI = NI – (SSS contributions + corporate income taxes + undistributed corporate profits) + transfer payments.

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Personal Disposable Income (DI)

Personal disposable income refers to the income left after deducting personal income taxes, which the individual has at his disposal to spend or to save.

DI = PI – Personal income taxes

Personal Savings(S)

Personal savings refers to income not spent for consumption.

S = DI – C

Or if there is interest paid by consumers

S = DI – (C + interest paid by consumers

Or there is interest paid by consumers

S = DI – (C + interest paid by consumers)

Measuring Economic Success

GNP shows us the economy’s performance, whether it is growing or shrinking, healthy or sick. When GNP increases, the economy is expanding. When GNP decreases, the economy is contracting. GNPcan be used also to compare one country’s economy with the economy of another and with itself over time.

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57


Name:___________________________________________Score:______

Section:_______________Room:______________________Date:_____

Exercise 3.1

Fill in the blanks:

1. _______ measures the market value of all the final goods and services produced.

2._____________________ is the study of the total performance of the economy.

3. The_____________________method to GNP counts the money spent for goods and services.

4. The _____________ method to GNP counts the money received for productions.

5. GNP only counts the __________ goods and services.

6._______________ is the difference between the cost of materials or product and the sale s value of goods.

7._________ is the cost of depreciation of capital assets.

8.__________________ is the other name of undistributed corporate profits.

9. Philippines uses the _____________method in the computation of GNP.

10_________________are the values of the goods sold outside the country.

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Name:____________________________________________Score:_____Section:_________________Room:_____________________Date:____

Exercise 3.2

Matching Type: Write the letter of the best alternative on the blank provided.

TERMS:

A. Net National Product H. Real-Gross National ProductB. Indirect Business Taxes I. Net private domestic investmentC. Disposable Income J. National IncomeD. Proprietors’ Income K. Per-capita Gross National ProductE. Depreciation L. DividendsF. Corporate income M. Undistributed corporate profitsG. Net exports N. Transfer Payments

______1. Measures output valued at the prices prevailing at a specific point of time.

______2. The sum of corporate income taxes, dividends and undistributed corporate profits.

______3. Portion of corporate profits, which is included in disposable income.

______4. The total income earned be resource suppliers.

______5. National income plus indirect business taxes.

______6. The income left after payment of personal income taxes.

______7. An allowance for capital goods consumed in the production of this year’s output.

______8. The part of profit paid out to the stockholders or owners of the corporations.

______9. The income of partnerships, proprietorships and cooperatives.

______10. The difference between gross private domestic investment and depreciation.

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Name: _____________________________________Score:_______

Section:___________Room:_____________________Date:_______

Exercise 3.3

Write if the item is included or reflected in GNP: _X__if not.

______1. A 3-teaching hour decline in the length of workweek of the UE faculty members.

______2. The services of a carpenter in repairing the roof of my house.

______3. Government Service Insurance System (GSIS) payments received by a retired government employee. ______4. Interest on a Central Bank Certificate of Indebtedness (CBCI)/bond.

______5. Monthly allowances received by the students from their parents.

______6. Wages paid to a cook in a restaurant.

______7. The market value of a homemaker’s service.

______8. John received P200,000 from selling his 3-year-old car.

______9. The income of a teacher,

_____10. I paid P120 to see a movie in SR movie house.

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Name:______________________________________ Score:___________

Section:_________________Room:______________Date:_____________

Exercise 3.4

1. Compute the following price indices’ and analyze what the data mean:

Price Price Index Year level (year 1 = 100) Interpretation

1 P10.00 _________ ____________

2 9.50 _________ ____________

3 9.80 _________ ____________

4 10.25 _________ _____________

5 10.25 _________ ____________

II. Compute the following price indices and analyze what the data mean:

Money GNP Real/adjusted GNP Year (in billion P) Price index

1 P550 110 ________

2 600 100 ________

3 840 120 ________

(a) The base year is year_______

(b) P700 is the real GNP in year________expressed in terms of prices paid in year_______.

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Name:______________________________________Score:___________Section:__________________Room:_____________Date:__________

Exercise 3.5

The three parts of this question represent three different problems. The figures are billions of pesos, and they refer to a specific year an (x) opposite each item means the value is not given.

ProblemTotal of A B C

1. Wages and salaries (x) (x) 952. Gross investment (x) (x) (x)3. Undistributed corporate profits 35 50 204. Transfer payments 30 50 155. SSS contributions 40 60 306. Government expenditures on

Goods and services 150 (x) (x)7. Rents (x) 60 208. Depreciation 50 85 359. Personal savings (x) 100 (x)

10. Corporate income taxes 10 25 5 11. Personal income taxes 60 80 30 12. Corporate income (x) 100 70 13. Net investment 50 (x) (x) 14. Consumption expenditures 200 300 (x) 15. Interests (x) (x) 15 16. Indirect business taxes 60 50 40 17. Proprietors income (x) (x) 55 18. Imports 10 30 (x) 19. Exports 35 10 (x)

A. For each problem, compute GNP, NNP, NI, PI, DI, and SB. Compute the total of the ff:

a. Dividend in problems B and Cb. Gross investment in problem Ac. Consumption expenditures in problem Cd. Net exports in problem A and Be. Personal savings in problem A

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Name:______________________________________Score:_______Section:___________________Room:______________Date:_______

Exercise 3.6

Given P (in billions)Net investment 50Personal income taxes 57Transfer payments 37Indirect business taxes 26Corporate income taxes 29Consumption expenditures 235Depreciation 25Interest paid by consumers 22Exports 33Government purchases of goods and services 69Undistributed corporate profits 28SSS contributions 22Imports 35

Compute:

A. GNP D. PI

B. NNP E. DI

C. NI F. S

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NATIONAL INCOME ESTIMATION

Learning Objectives

1. Use the linear consumption model to understand consumer behavior and explain why it best describes a consumption function.

2. Discuss the determinants of consumption and saving and give example each.

3. Understand the concept of AC, APS, MPS and how to calculate it.

4. Define investment in economic sense and distinguish it from the accounting concept.

5. Know the determinants of investments.

6. Determine the equilibrium level of output in the economy through aggregate spending approach and saving = investment approach.

Key terms:

Consumption function marginal propensity to consume

Consumption schedule marginal propensity to save

Savings investment

Savings schedule aggregate demand

Average propensity to consume aggregate supply

Average propensity to save multiplier

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CHAPTER 4

NATIONAL INCOME ESTIMATION

All market economies experience swings in business activity whenever national income fluctuates. When it does, people cannot help but wonder why such phenomenon occurs. What forces the drive the economy to change? What determines the equilibrium level of income? What factors cause such a change?

In this chapter we attempt to answer these questions by assuming a highly simplified economy, which consists only of the households and the business firms. From this basic model, we proceed to develop the concept of aggregate demand, aggregate supply, and the equilibrium level of income.

Consumption, Savings, Income

Consumption, savings and income are interrelated concepts in macroeconomics. Consumption, which is the household spending on final goods and services, is the main component of aggregate expenditures. Savings is the part of disposable income not spent on consumption. Disposable income is income available for consumption and savings. How do these concepts relate with each other?

Economic studies show that the most significant factor affectingConsumption and savings is income, in particular disposable income. The higher the income, the higher is the level of consumption and vice versa. There is a positive relationship between income and consumption. LikewiseThe higher the income, the more chances people can save. Consumption and savings rise with disposable income.

Consumption Function

An equation showing the relationship between the level of consumption and the level of disposable income. C = f (Y) meaning consumption depends on income.

C = a + b Y

Intercept, > 0

Slope, MPC, > 0 < 1

income

Ex. C =40 + 80 Y

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Consumption Schedule

A schedule showing the amounts households plan to spend for consumer goods at different levels of disposable income.

Table 4.1

Consumption Schedule

Column (1) shows the different levels of disposable income while column (2) represents consumption spending. Columns (1) and (2) taken together is called the consumption schedule. At lower levels of income P4000 and P6000 household spend a larger proportion of their disposable income than that of a higher one and people tend to dissave,C>Y. As income rises to P8000 they tend to break-even. Consumption is exactly equal to disposable income, no savings/no dissavings. At incomes P10000 and P12000 households tend to save, C < Y. 63

C

12000

10000

8000

6000

4000

2000Y

0 2000 4000 6000 8000 10000 12000

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Y(1)

C(2)

P 4000 P 5000 6000 6500 8000 8000 10000 9500 12000 11000


Fig. 4.1

Figure 4.1 illustrates the income-consumption relationship. A reference line, 45 line, is drawn northeast from the point of origin. Any point along the 45 line shows the exact equality between consumption and disposable income. If a point lies above the 45 line there is a dissaving and if below, a saving.

Saving Function

Savings is unspent income. It shows how much households plan to hold back from consumption at different levels of income. Since disposable income is also the basic determinant of savings, it can be noted that savings is a function of income. Savings depend on income; household savings increases with increases in income and falls with decrease in income.

Table 4.2 shows the various amounts of savings that households will undertake at different levels of income. Savings is disposable income minus consumption.

Table 4.2

Saving Schedule

Y C S

(1) (2) (3)

P 4000 P5000 P-1000

6000 6500 -500

8000 8000 0

10000 9500 500

12000 11000 1000

Column (1) shows the levels of disposable income while column (2) represents consumption. Column (3) savings is derived by subtracting (2) from (1).

At lower levels of income households cannot afford to save. Disposable income is insufficient to meet consumption expenditures. Hence, savings is negative (dissaving).

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As income rises, there will come a point where consumption will be equal to income. Households will be at break-even and savings is zero. At high levels spending will be less than income and there is savings. This table illustrates the positive relationship between income and savings.

Fig. 4.2

Figure 4.2 shows the income-savings relationship. If a point falls along the income (Y) axis, households are breaking even hence savings is equal to zero. However, if a point lies above the income (Y) axis, there is a saving, (S+) and below the income axis, dissaving (S-).

Average and Marginal Propensities

APS and APS

The fraction of total income that is consumed is the average propensity to consume (APC). The fraction of total income that is saved is the average propensity to save (APS). That is

APC = Consumption = C Income (Y) Y

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APS = Saving = S Income Y

Therefore APC + APS = 1

Example:

Table 4.3

Propensities to Consume and Save

Y C S APC APS MPC MPS (1) (2) (3) (4) (5) (6) (7)

P4000 P5000 P-1000 1.25 -.25 .75 .25

6000 6500 -500 1.08 -.08 .75 .25

8000 8000 0 1 0 .75 .25

10000 9500 500 .95 .05 .75 .25 12000 11000 1000 .92 .08 .75 .25

APC = C = 5000 = 1.25, APS = s = -1000 = .25, APC + APS =1 4000 4000

To calculate APC, we use the data on income and consumption, for example, at P4000, AP 5000 = +1.25 4000

Columns (4) and (5) shows the APC and APS at the different levels of income.

Marginal Propensities: MPC & MPS

The marginal propensity to consume is the extra amount that people consume when they receive an extra disposable income. The response of consumption to change in income is called MPC. On the other hand, marginal propensity to save (MPS) is the proportion or fraction of any change in income that is saved.

MPC = change in consumption = ΔC = C2 – C1 Change in income ΔY Y2 – Y1

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MPS = change in saving = ΔS = S2 – S1 Change in income ΔY Y2 – Y1

Where Δ is Greek letter “tetta” which is used to denote “change”For example, income rises by P2000 from P4000 to P6000 as seen in Table

4.3 Consumption grows from P5000 to P6500, an increase of P1500. The extra consumption is 0.75 of the extra income.

MPC = C2 - C1 = 6500 – 5000 = 1500 = 0.75 Y2 – y1 6000 – 4000 2000

MPS = S2 – S1 = -500-(1000)= -500+1000 = 500 = 0.25 Y2 – Y1 = 6000=400 2000 2000

MPC + PMS = 1

.75 + .25 = 1

Non-income Determinants of Consumption

The amount of disposable income is the central factor in determining a household consumption and saving. However, there are factors other than income which might influence households to consume more or less at each position level of income and thereby shift the location of consumption and savings schedules. These are:

1. Amount of wealth owned by households2. Expectations of future prices and income3. Real interest rates4. Consumer indebtedness5. Tax levels

SHIFTS IN CONSUMPTION AND SAVING SCHEDULES

C

C1

C0

C2

Y

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. Fig. 4.3 (a) Consumption Schedule

S2

S0

S1

Y

Fig. 4.3 (b) Savings Schedule

If households consume more at each level of disposable income they save less. Graphically, the movement is from C to C in Fig 4.3(a) and S to S in 4.3(b (. On the other hand, if households consume less, they save more. The movement is toward the opposite direction.

Investment

The second major component of aggregate expenditure is investment. Investment refers to purchases of machinery, equipment and tools, all construction and changes in inventories. Firms invest to earn profits. However the level of investment rests in several factors, namely, expected rate of return, interest rate and expectations and business confidence. Because the determinants of investment depend on the highly unpredictable future events, investment is said to be the most volatile component of aggregate spending.

Table 4.4

Investment demand schedule

Rates of Expected Return and Investment

Expected rate of return (r) Vol. of 1 (Billion/yr)

10 P 0 8 5 6 104 152 200 25

Table 4.4 shows the amount of investments and the expected rate of return. Suppose no investment opportunity will yield an expected rate of return of 10% but there

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are P5B worth of investment opportunities with expected rates of return 8%. People will continue to invest until such a time when expected rate of return of P25B will be zero.

Investment Demand Curve

Fig 4.4

The investment demand curve slopes downward reflecting an Inverse relationship between the interest rate and the quantity of investment demanded.

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Aggregate Demand, Aggregate Supply, and Equilibrium

After developing the concept of consumption and investment as tools for understanding how national output and price level is determined, we now explore the foundation of aggregate demand. What are its components? How do they interact with aggregate supply to determine output and prices?

There are two approaches in the determination of equilibrium level of employment output and income. The aggregate demand-aggregate supply approach and savings=investment approach.

Aggregate Demand-Aggregate Supply

Aggregate demand refers to the quantity of goods and services that consumers and firms would be willing to buy at any given price level. It represents the total output that would be willingly bought at each price level given the monetary and fiscal policies and other factors affecting demand.

Aggregate supply describes what output business would be willing to produce and sell given prices, costs, and market conditions. Aggregate supply is a function of available inputs, technology and the price level. The equilibrium level of income refers to that income level where aggregate demand equals aggregate supply.

Example 1

Table 4.5

Aggregate Demand & Aggregate Supply Schedules

Aggregate Supply C I Aggregate Demand

(Output Income) (C+1)

(1) (2) (3) (4)

P4000 P5000 P500 P5500

6000 6500 500 7000

8000 8000 500 8500

10000 9500 500 10000

12000 11000 500 11500

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Table 4.5 shows the derivation of aggregate demand. To determine aggregate demand simply add the values of consumption (col.2) and planned investment (col.3). Using the above data, at income level P8, 000 below, consumption plus investment spending exceeds aggregate supply or output. At income levels above P10, 000 , consumption (C) and investment spending (I) is less than output. Aggregate demand (AD)= aggregate supply (AS) at income P10,000.

Fig. 4.4

Fig 4.4 shows the graphical

presentation of the equilibrium level income. The 45 line, which used to be the reference line, is now referred to as the aggregate supply. It shows the exact equality between spending and the different levels of income. Consumption line is plotted using the data from table 4.5 so with the consumption plus investment line (C+I). The point where aggregate demand equals aggregate supply at income P10,000 is called the equilibrium level of income.

Savings – Investment

Savings, which is unspent income, is considered a leakage in the circular now because if people save money, some goods remain unsold. It lessens the money circulation. On the other hand, investment spending is an injection of funds because it firms invest; they infuse money in the circular stream. For an economy to be in equilibrium, the amount saved must be offset by an equal amount of investment.

Example 2

Table 4.6

Savings – Investment Schedules

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Aggregate Supply C S I Aggregate Demand

(Output/Income)

(1) (2) (3) (4) (5)

P4000 P 5000 P-1000 P500 P5500

6000 6500 -500 500 7000

8000 8000 0 500 8500

10000 9500 500 500 10000

12000 11000 1000 500 11500

Table 4.6 shows the planned level of savings and the planned level of investment. Recall that Y = C=S. To determine savings (col.3), simply subtract column (2) from column (1) S=Y-C. Note that the level of investment spending is constant at P500. This is the autonomous investment. It doesn’t change the level of income.

Table 4.5

Multiplier Effect

The multiplier effect shows the number of times in which the ultimate increase in income exceeds the initial increase in investment spending. It is also the reciprocal of MPS.

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K= 1 = 1 = Y , since S=I, Ke = Y 1-MPC MPS S I

Example 3: Assume that consumption spending is represented by the equation C=40+80Y. Recall that C+a+b Y where b represents MPC. To compute for Ke:

Ke = 1 Ke = 11 – MPC MPS

= 1 = 1 1-.80 .20= 1 = 5 .20

= 5

There is a multiplier effect because consumption depends upon the level of disposable income. The value of the multiplier increases with increases in MPC and falls as MPC falls. Hence a positive relationship exists.

The Keynesian multiplier model would help us understand why changes in consumption as well as investment spending determine movements in national output, prices and employment.

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