Applied Economics

LECTURE 1: INTRODUCTION TO ECONOMICS

ECONOMICS- a social science that deals with the allocation of scarce resources to satisfy man’s unlimited needs and wants

SCARCITY- insufficiency of resources to meet all the needs and wants of a population

RELATIVE SCARCITY- a good is scarce compared to its demand

Example: Bananas are abundant in the Philippines but when typhoon destroys banana plants, they become relatively scarce.

ABSOLUTE SCARCITY- supply is limited

Example: oil is absolutely scarce in the Philippines so we rely heavily on imports from oil producing countries like Iran

TRADE OFF- choosing one thing over the other possibilities

OPPORTUNITY COST- refers to the value of the best foregone alternative

-       Value of things that could have gained from alternatives that were not selected

ECONOMIC RESOURCES

-       also known as factors of production

-       resources used to produce goods and services

1.     Land- soil and natural resources

-       payment for land owners is rent

2.     Labor- physical and human effort exerted in production

-       income received is wage

3.     Capital- man-made resources used in production of goods and services

-       income is interest

SOCIAL SCIENCE- study of society and how people behave and influence the world around them

ECONOMICS AS SOCIAL SCIENCE- economics studies how individuals make choices in allocating scarce resources to satisfy their unlimited wants based on their social behaviors

TWO DIVISIONS OF ECONOMICS:

MACROECONOMICS

- division of economics that is concerned with the overall performance of the entire economy

- it focuses on the overall flow of goods and resources and studies the causes of change in the aggregate flow of money, the aggregate movement of goods and services and the general employment of resources.

MICROECONOMICS

- concerned with the behavior and decisions of individual entities such as the consumer, the producer, and the resource owner

- it is more concerned on how goods flow from the business firm to the consumer and how resources move from the resource owner to the business firm.

BASIC PROBLEMS OF SOCIETY

1.     What to produce and how much

2.     How to produce

3.     For whom to produce

ECONOMIC SYSTEMS- means through which society determines the answers to the basic economic problems

1.     Traditional economy

-       traditional societies exist in backward and primitive civilizations

-       Methods are stagnant and therefore, not progressive

-       Practiced in indigenous communities where life is less complicated and the simple needs of the society can be self-produced

2.     Command System

-       authoritative system

-       decision-making is centralized in the government or a planning committee

-       The state or agency of government maybe in charge in the allocation of resources by using its political power in answering the basic economic problems

-       This economy exists in dictatorial, socialist and communist nations

-       Sometimes the government declares authoritative system in times of calamities, disasters, or national emergencies

o   Example:

o   Typhoon destroyed crops, damaged houses and business establishments. The government will:

§  Ration commodities

§  Impose price control

§  Confiscate resources

3.     Market Economy

-       The most democratic from of economic system

-       People’s preferences may reflect on the prices they are willing to pay in the market which becomes

the basis of the producers’ decisions on what goods to produce

-       There is Equilibrium price and output in the market

-       The basic economic problems are answered based on the workings of demand and supply

 LECTURE 2: ECONOMICS AS AN APPLIED SCIENCE

ECONOMICS AS AN APPLIED SCIENCE

-        Using of tools such as logic, mathematics, and statistics so students can do empirical testing of an economic theory in a scientific manner

SCIENTIFIC METHOD – A method of inquiry from identifying a problem, proposing alternative tentative answers or hypotheses, testing the tentative answers to question or problems at hand, gathering and treating the data, and answering the question through the conclusion

-        Statistics and econometrics are used as empirical proof in testing the hypothesis

POSITIVE ECONOMICS VERSUS NORMATIVE ECONOMICS

Positive Economics

-        Deals with “what is”

-        things that are actually happening like current inflation rate, number of employed labor, or level of Gross National Product.

-        An overview of what is happening in the economy that is possibly far from what is ideal

Normative Economics

-        Deals with “what should be”

-        It embodies the ideal such as the ideal rate of population growth or the most effective tax system

-        Focuses on policy formulation that will help to attain the ideal situation

MEASURING THE ECONOMY

GROSS NATIONAL PRODUCT (GNP)

-        The market value of final products, both sold and unsold, produced by the resources of the economy in a given period

GROSS DOMESTIC PRODUCT (GDP)

-        The market value of final products produced within the country

GNP/GDP EXPENDITURE APPROACH

-        Products are final when they have reached the highest level of processing

o   These are household and individual consumption (C), and government expenditure on goods and services including labor (G) and exports (X)

-        Products, regardless of production stages, are also considered final when basically stocked (unused) as capital goods and inventories of raw materials and intermediate products

o   Classified  as investments (I), they are stock of values for future use

-        Import components (M) are excluded since they are produced in other economies

Equation:

GNP= C + I + G + (X – M)

GNP/GDP INCOME APPROACH

-        Another way to account GNP and classify its components is by resource uses and contributions that make up the production stages

-        Basic factors of production add value to products as they are processed into higher forms. If all payments for resource contributions (rent, wage, interest, profit) went to resource owners, GNP would simply be the sum of all factor payments from the raw material to the final production stage

CHAPTER 2: APPLICATION OF DEMAND AND SUPPLY

THE MARKET

-        An interaction between buyers and sellers of trading or exchange

-        It is where the consumers buy and the seller sells

o   Goods market- where we buy consumer goods

o   Labor market- where workers offer services and look for jobs and where employers look for workers to hire

o   Financial market- where securities of corporations are traded

LECTURE 3: BASIC PRINCIPLES OF DEMAND

DEMAND

-        The willingness of a consumer to buy a commodity at a given price

DEMAND SCHEDULE

-        It shows the various quantities the consumer is willing to buy at various prices

DEMAND FUNCTION

-        It shows how the quantity demanded of a good depends on its determinants, the most important of which is the price of the good itself

Qd= f (P)

DEMAND CURVE

-        A graphical illustration of the demand schedule, with the price measured on the vertical axis (Y) and the quantity demanded on the horizontal axis (X)

Example demand function:                               Qd= 6-P/2

Demand schedule for bottles of vinegar given the following prices:

Computation based on demand function Qd= 6-P/2

Qd= 6- (0/2)= 6                                     Qd= 6-(6/2)= 3

Qd= 6-(2/2)= 5                                      Qd= 6-(8/2)= 2

Qd= 6-(4/2)= 4                                      Qd= 6-(10/2)= 1

-        There is negative relationship between the price of a good and the quantity demanded for that good

-        At a lower price, consumer buys more and at a higher price, consumption tends to go down

-        The downward slope of the curve indicates that as the price of a commodity increases, the demand for this good decreases

-        The negative slope of the demand curve is due to income and substitution effects

o   Income effect

- it is felt when a change in the price of a good changes consumer’s real income or purchasing power

- if a good becomes more expensive, real income decreases and the consumer can only buy less goods and services

o   Substitution effect

- it is felt when a change in the price of a good changes demand due to alternative consumption of substitute goods; consumers substitute expensive goods with cheaper goods

THE LAW OF DEMAND

-        As price increases, the quantity demand for that product decreases, other things held constant (ceteris paribus)

-        There is an inverse relationship between the price of a good and the quantity demanded

CETERIS PARIBUS

- all other related variables are held constant except those that are being studied at the moment

- other factors that may affect the demand for the commodity are not changing and the only factor that influences the level of demand is the price only

NON-PRICE DETERMINANTS OF DEMAND

-        If ceteris paribus is dropped, non-price variables that also affect demand are now allowed to influence demand (income, taste, expectations, prices of related goods and population)

-        Demand function will be: D= f( P, T, Y, E, PR, NC ) which states that demand for a good is a function of price (P), taste (T), income (Y), expectations (E), price of related goods (PR), and the number of consumers (NC)

-        The demand curve will shift to the right to reflect increase in demand and shift to the left to show decrease in demand due to non-price determinants

1.         Income – the income of the consumer influences the capacity to purchase

                        Income ↑ QD↑           Shift to the right

                        Income ↓ QD↓           Shift to the left

2.         Prices of related goods

a.         Substitute

                        PSUBSTITUTTE ↑ QD of Chosen Good↑           Shift to the right

                        PSUBSTITUTTE ↓ QD of Chosen Good↓           Shift to the left

b.         Complementary

                        PCOMPLEMENTARY ↑ QD of Other Complement ↓                 Shift to the left

                        PCOMPLEMENTARY ↓  QD of Other Complement ↑                Shift to the right

3.         Expectation – prospect of what is going to happen to the price can influence the demand of a commodity

                        PFUTURE ↑ QD↑                     Shift to the right

                        PFUTURE ↓ QD↓                     Shift to the left

4.         Taste – preference that may influence the demand for a commodity

Factors affecting taste:

a.         Cultural values

b.         Peer pressure

c.         Power of advertising

                        Taste ↑ QD↑              Shift to the right

                        Taste ↓ QD↓              Shift to the left

5.         Number of consumers (market) – size and characteristic of the population

                        Population ↑ QD↑                  Shift to the right

                        Population ↓ QD↓                  Shift to the left

 LECTURE 4: BASIC PRINCIPLES OF SUPPLY

SUPPLY

-        It refers to the quantity of goods that a seller is willing to offer for sale

SUPPLY SCHEDULE

-        It shows the different quantities the seller is willing to sell at various prices

SUPPLY FUNCTION

-        It shows the dependence of supply on the various determinants that affect it

SUPPLY CURVE

-        A graphical presentation of the supply schedule; it is upward sloping indicating the direct relationship between the price of the good and the quantity supplied of that good

Example of supply function:      Qs= 100 + 5P

Supply schedule (based on given supply function above):

Computation based on the supply function Qs= 100 + 5P

Qs= 100 + 5 (20)= 200

Qs= 100 + 5 (40)= 300

Qs= 100 + 5 (60)= 400

Qs= 100 + 5 (80)= 500

Qs= 100 + 5 (100)= 600

THE LAW OF SUPPLY

-        Under the assumption of ceteris paribus, there is direct relationship between the price of a good and the quantity supplied of that good

-        As the price increases, the quantity supplied of that product also increases

NON-PRICE DETERMINANTS OF SUPPLY

1.     Price of Production Input – value added to raw materials through the process of production

Intermediate Input – raw materials; these are still going to be processed or transformed into higher levels of output

            Examples:

            Lumber

            Oil

            Mineral

Factor Input – processing or transforming input

            Examples:

            Labor

            Capital

            Land

                        PPRODUCATION INPUT ↑

Cost of Production↑ QS↓

                        PPRODUCATION INPUT ↓

Cost of Production↓ QS↑

2.     Taxes – monetary expense paid to the government

Taxes ↑ QS↓

3.     Technology – the manner in which factor inputs process intermediate inputs is done through technology

            Improvement or discovery in technology

Improved technology (Cost of Production) ↑ QS↓

Obsolete technology (Cost of Production) ↓ QS↑

4.     Expectation – anticipation on what is going to happen on the price of the commodity

PFUTURE ↑ QS↑

            PFUTURE ↓ QS↓

5.     Availability of raw materials and resources

Materials and Resources ↑ QS↑

            Materials and Resources ↓ QS↓

NOTE:

-        Once supply increases due to a non-price determinant, the entire supply curve will shift to the right; the supply curve will shift to the left to reflect a decrease in supply.

LECTURE 5: MARKET EQUILIBRIUM

In a market economy, a price is derived or determined if the forces of demand and supply operate together.

Equilibrium

-       a state of balance when demand Is equal to supply

-        This equality shows that the quantity that sellers are willing to sell is also the quantity that buyers are willing to buy for a price

Market equilibrium is attained at the point of intersection of the demand and supply curve.

DETERMINATION OF MARKET EQUILIBRIUM

Assuming that the demand function for Good X is:

Qd= 60- P/2

And the supply function for Good X is:

Qs= 5 + 5P

Applying the equations, we derive the following demand and supply schedules given the prices below:

Equilibrium quantity is attained where Qd= Qs

Equilibrium quantity is 55 and the equilibrium price is P10.

Through computation:

60-P/2= 5+5P

60-5= 5P + P/2

2(55)= (5P + P/2) 2

110= 10 P + P

110/ 11= 11P/11

P= 10

Now, substitute the price P10 to the Qd and Qs functions:

For Qd:                                                           

Qd= 60- P/2

Qd= 60 – (10/2)

Qd= 60 – 5

Qd=55

For Qs:

Qs= 5 + 5P

Qs= 5 + 5 (10)

Qs= 5 + 50

Qs= 55

-           The ideal situation in market economy is at the point where the demand and supply curves intersect, which is known as market equilibrium as mentioned above. However, during relative scarcity (shortage) and overproduction (surplus), the government may intervene to control the price in the market.

-           The problem of scarcity is addressed through the changes in price and the corresponding responses of buyers and sellers

Example:

1.         In case of shortage, the price normally increases

Corresponding response in the market:

Buyers – Decrease demand

            Sellers – Increase supply

In this case, a price ceiling is set by the government to protect the buyers

2.         In case of surplus, the price normally decreases

Corresponding response in the market:

Buyers – Increase consumption

Sellers – Reduce production

In this case, a price floor is set by the government to protect the sellers

 LECTURE 6:       ELASTICITY OF DEMAND AND SUPPLY

-        Goods differ on how demand and supply respond to changes in their determinants

-        This degree of response to a change is called elasticity

ELASTICITY- it is a measure of how much buyers and sellers respond to changes in market conditions

-        The coefficient of elasticity is obtained when the percentage change in demand is divided by the percentage change in determinant.

DEGREES OF ELASTICITY

1.     Elastic- a change in determinant will lead to a greater change in demand or supply

-        The absolute value of the coefficient of elasticity is greater than 1.

Example: The price of LPG increases by 10% and the quantity demanded decreases by 12%

Elasticity= 12 / 10

= 1.2

Then the demand for LPG is elastic

2.     Inelastic- a change in determinant will lead to a lesser change in demand or supply

-        The absolute value of the coefficient of elasticity is less than 1.

Example: The price of cellphone goes up by 5%; quantity demand goes down by 3%

Elasticity= 3/5

= 0.6

Then the demand for cellphone is inelastic

3.     Unitary elastic- a change in determinant will lead to an equal change in demand or supply

-        The absolute value of the coefficient of elasticity is equal to 1.

Example: The price of beans decreases by 6%; quantity demand increases by 6%

Elasticity= 6/6

= 1

Then the demand for beans is unitary elastic

3 TYPES OF ELASTICITY OF DEMAND:

1.     Price elasticity

2.     Income elasticity

3.     Cross price elasticity (price of related goods- substitute or complement)

*Price elasticity of demand

-        It measures the responsiveness of demand to a change in the price of the good

-        Price elasticity is measured in two ways:

1.     Arc elasticity- the value of elasticity is computed by choosing two points on the demand curve and comparing the percentage change in the quantity and the price on those two points.

Formula:

Ep= ((Q2-Q1)/ ((Q2+Q1)/2)) ÷ ((P2-P1)/ ((P2+P1)/2))

Where:

            Q2= new quantity demanded

            Q1= original quantity demanded

            P2= new price of the good

            P1= original price of the good

2.     Point elasticity- measures the degree of elasticity on a single point on the demand curve

Formula:

Ep= ((Q2-Q1)/Q1) ÷ ((P2-P1)/ P1)

Price elasticity is important to the seller since it gauges how far demand can change relative to price

*Income elasticity of demand

-        This measures how the quantity demanded changes as consumer income changes

Income elasticity of demand= % change in Qd ÷ % change in income

Normal good= goods bought when income increases

Inferior good= goods bought when income decreases

*Cross Price Elasticity of Demand

-        This measures how quantity demanded changes as the price of a related good (substitute or complement good) changes

PRICE ELASTICITY OF SUPPLY