First Handout in Microeconomics

Objectives
At the end of the chapter, the student is expected to:
1. Define basic economic terms;
2. Identify the elements involved in the objective of satisfying wants;
3. Differentiate economic analysis and economic policy;
4. Describe the methodology used in the scientific approach in studying economics;
5. Itemize the characteristics of microeconomics;
6. Apply the use of economic models in economic analysis;
7. Present an overview of the circular flow in the economy; and
8. Differentiate the types of economic systems.

Today, people are getting to be more and more concerned about economics. The current economic situation
seems to interest everybody in society: the provider, the laborer, the bank teller, the accountant, the college
professor, and even the student. While some of these people have no actual background in economics, it comes as a
challenge for a college student to familiarize himself with what economics is all about. He gets to learn how to
analyze economic theory and to explain why things are happening in the economy.
With today’s emphasis on economics, it is an advantage to have knowledge on economic theory.

Terms to Remember
 basic needs - man’s needs required for his survival
 capital - materials used in the production of goods and services including money
 economic resources — inputs used in the production of goods and services
 economic system — the framework in which society decides on its economic problems
 economics - a social science concerned with man’s problem of issuing scarce resources to satisfy unlimited
wants
 empirical validation — the use of statistical evidence to prove the validity of a hypothesis
 entrepreneur — organizes all other factors of production to be used in the creation of goods and services
 free enterprise system — a system in which all economic resources are privately owned. Individuals are free to
engage in a business of their choice
 function — depicts the relationship between two or more variables. It shows how one variable, called the
dependent variable, depends on another variable or variables, called the independent variables. For example,
the demand function shows how demand, the dependent variable, varies according to a change in price, the
independent variable
 labor — human effort expended in production regarding basic economic problems
 land - natural resource, not man-made, covering anything found on or under land, water, forests, minerals, and
animals
 luxury goods - goods that man can do without
 macroeconomics — the branch of economics that studies the economy as a whole; also known as national
income analysis
 market — context in which buyers and sellers buy and sell goods, services, and resources
 microeconomics — the branch of economics that deals with parts of the economy such as the household and the
business firm; also known as price theory
 normative economics - an analysis of economics which deals with what should be
 positive economics - an analysis of economics which deals with what actually is
 right to private property ~ the right of private individuals and enterprises to own things of value
 theory / hypothesis - an unproven proposition tentatively accepted to explain certain facts or to provide a basis
for further investigation
 variable — a factor that is subject to change or variation
 wants — the various desires and needs of consumers that have to be satisfied through the use of goods and
services
 Introduction
Over the past years, the study of economics has widened to encompass a wider notion of topics. Samuelson and
Nordhaus' Economics (2001) mentioned the major definitions in this growing subject. Among these are
1. Economics studies how prices of land, labor, and capital are determined, and how these prices are used to allocate
scarce resources.
2. Economics looks into the behavior of financial market and how it allocates capital to the rest of the economy.
3. Economics looks into the distribution of income and into ways of helping the poor without causing harm to the
country’s economic performance.
4. Economics studies the impact on growth of government spending, taxes, and budget deficits.
5. Economics examines the movements in income and employment during the dif ferent stages of the business cycle
with the goal of developing government policies that will improve economic growth.
6. Economics looks at trade patterns among nations and analyzes the impact of trade barriers.
7. Economics examines growth in developing countries and suggests ways to encourage the efficient use of resources

ECONOMIC ACTIVITY
Man's Basic Economic Activity
Man’s basic economic activity consists of effort’s to satisfy human wants with the use of goods and services.
Three elements are involved in this objective of satisfaction as discussed in this section.
The first is human wants. The best description that can be made of human wants is that they are unlimited and
vary from the needs for survival, otherwise known as basic needs (e.g., food, clothing, and shelter) to higher needs for a
comfortable and more meaningful life. In addition, man is subject to create wants, develop them due to the effects of
advertising and demonstrative effects of consumption as dictated by our culture Thus, one may be influenced to buy an
iPad, laptop, or iPod only because others have it. Economics is concerned with the satisfaction of many of these human
wants especially the basic ones.
The second element is the use of resources. The basic economic resources of a nation consist of land, labor,
capital, and entrepreneurship. Since these items are available in limited amounts, man has to learn to allocate them
properly in order to maximize the number of wants that can be satisfied. The economy should pay the owners of these
basic factors of production for the use of their resources such as rent for land, wage or salary for labor, interest for
capital, and profit for entrepreneurship.
The last element is the technique of production which shows how resources are used and combined in production.
Thus, production is described as capital intensive or labor-intensive depending cm what factor is predominantly used.
In effect, the basic activities of man also constitute the basic exchange that takes place between the business firm
and the consumer.
Resources Payment

Land Rent

Labor Wage/Salary

Capital Interest

Entrepreneurship Profit

CONSUMPTION
The household is the basic consuming unit in the economy. Since human wants are unlimited, humans maximize
their satisfaction through the proper allocation or mix of expenditures within the context of budget limitations. For
example, a student has an allowance to budget usually for a given week. Five hundred pesos goes to transportation,
sandwiches, soft drinks, and even an occasional movie. However, a decision to buy a new T-shirt means giving up some
snacks at school as the satisfaction that will be gained from the former will outweigh the satisfaction foregone from
the latter. The opportunity foregone is called opportunity cost, defined as the value of a foregone alternative of a specific
resource. Opportunity cost may also be exemplified in the earning value of a university ground had it been used as a
commercial center instead of an educational institution.
The business firm serves as the economy’s producing unit to satisfy human wants with goods and services. For
example, production must take place in a factory before Shoe mart can sell beautiful high-heeled pairs of shoes. The
entrepreneur had to hire shoe cutters and sewers and skilled workers; buy leather, thread, metals, paste, shoe-making
machineries; and work on all these materials to come out with different shoe designs and colors.
The use of resources generates income for the resource owners. The owners of land in which a factory is
constructed charge rent for the use of their property. The shoe cutters, pattern makers, dyers, and other workers have
to be paid wages for their efforts expended in production. The owner of the business has to forego the alternative use
of his money to invest in the business for which he charges interest. Even the entrepreneur has to do something out of
pooling these resources for production to gain income or profit. It is the entrepreneur who basically makes the
decision as to how production resources should be best combined to come up with the desired output.

Some Economic Problems

Most societies aim to use economic activity as a channel to improve the people’s standards of living within the
limits of available resources. Hence, a government can restructure the economic system in order to solve its
shortcomings or problems like:
1. Unemployment;
2. Economic instability that causes highs and lows in production and investment levels;
3. Low levels of growth and development, which make them more difficult for underdeveloped and developing
nations to rise from their low levels of income and employment;
4. Inequality in income distribution resulting in the concentration of the nation’s wealth in the hands of a few; and
5. Determination of the type of economic system to be adopted to meet the coun try’s peculiar conditions and
needs.
Unemployment is a problem because it leads to the existence of idle resources. This means that income is
foregone on resources which would generate earnings to the owner if used.
Furthermore, economic instability in a nation makes it difficult for producers to make accurate forecasts on
demand and consumption levels. This would cause fluctuations in their production and supply of goods and services
resulting in surpluses or shortages of goods.
Poor countries especially suffer from low levels of economic growth and development. They get caught in the
vicious cycle of poverty, making it difficult to get started on their development. Their low levels of income deter them
from channeling funds to investments in order to propel economic growth.
On the other hand, the problem of unequal income distribution exists when too many people in the nation that
belong to the low income group cause a pyramidal structure in the economy. The base, which is made up of the
majority of the population, is the low income earners who can only afford to satisfy their basic needs. The wealth of the
nation is concentrated in a small number of families who control the bulk of the country’s purchasing power.
Lastly, the choice of the nation’s economic system is vital to any country because it determines the manner in
which goods will be produced, the quantities of each good that will be produced, and the distribution of these goods
and services.

Economic Analysis and Economic Policy

Economic analysis is the process of directing economic relationships by examining economic behavior and
events, and determining the causal relationships among the data and activities observed.
A student in economics who attempts to analyze relationships among economic variables must learn to draw
conclusions from the particular to the general, or through deductive reasoning, which draws conclusions from the
general to the particular. This necessitates the use of the first tool of Economics which is logic.
On the other hand, the economic analyst uses statistics to quantitatively describe economic behavior and
therefore serves as a basis in hypothesis testing. A hypothesis becomes a principle or theory one empirically validated.
The third tool of economics is mathematics which enables the analyst to conceptualize and quantify a
hypothesis for empirical validation.

Purposes of Economic Analysis

1. Economic analysis is an aid in understanding how an economy operates because it explains how economic
variables are related to one another.
2. It permits prediction of the results of changes in the economic variables.
3. It serves as basis of policy formulation.
Economic Policy
Economic policy consists of intervention or courses of action taken by the government or other private
institutions to manipulate the results of economic activity. The economic policy adopted by the government may be
monetary, fiscal or trade for the purpose of achieving economic welfare.

Methodology
To make a useful, systematic study of economic activity, one must use economic theory. But what is economic
theory? Like the theory of any other science, it consists of sets of principles or causal relationships among the
important “facts” or variables that surround and permeate economic activity. We look first at the construction of and
functions of sets of economic principles; then we turn to the place of price theory within the overall framework of the
economics discipline.

The Construction of Economic Theory

Any set of principles, or theory, must have a bedrock starting points consisting of propositions or conditions that
are taken as given --that is, as being so without further investigation. These we call the premises or postulates upon
which the theory is erected. In aerodynamics the forces of gravity, the operation of centrifugal force, and air resistance
may be among the postulates of a theory involving lift, thrust, and drag. In economics we may build a theory of
consumer behavior on the postulate of consumer rationality, defined as the general desire of consumers to secure as
much satisfaction as they can in spending their incomes. The first step, then in the construction of a theory is the
specification and definition of its postulates.
The second step is the observation of "facts” concerning: the activity about which we want to theorize. For
example, if the activity in question is the exchange of groceries between supermarkets and consumers, the activity
should be looked into as thoroughly as possible. As facts emerge from continued and repeated observation, it will
become apparent that some are irrelevant and can be discarded while others are obviously significant.
In the grocery exchange case, the hair color of consumer is not likely to matter, but the weekly amounts of money
that consumers have to spend, the number of supermarkets available to the, and the weekly Quantities of groceries
available to be purchased will most certainly be important.
The third step-- and this one will frequently be taken concurrently with the second -— is the application of the rules
of logic to the observed facts in an attempt to establish causal relationship among them and to eliminate as many
irrelevant and insignificant facts as possible. Deductive chains of logic may lead us to believe that certain effects follow
certain causes in a regular manner. We may reason that because consumers with larger incomes are willing to pay
higher prices for specific goods, an increase in consumer incomes is likely to lead to higher prices,. Or, on the other
hand, we may reason inductively. Repeated observations may indicate that increases in consumer incomes and
increases in prices occur simultaneously. So, putting two and two together, we reach the tentative conclusion that
higher incomes cause prices to rise. Such tentative statements of cause and effect relationships tire called hypothesis.
The fourth step in the process of establishing: a set of principles is a crucial one. One hypotheses have been
formulated, they must he thoroughly tested to determine the extent of which they are valid, that is, the extent to which
they yield good explanations and predictions. The tools of statistics and econometrics are of particular value in this
respect. Some hypotheses will not withstand the rigors of repeated testing, and conseq uently, must be rejected. Others
may look promising with modifications then, the modified hypotheses must he tested. Still other hypotheses may he
found to hold up most of the time in most of the circumstances to which they are relevant. These we usually refer to as
principles.
It would be foolish to regard a set of principles or a theory as absolute truth. The testing process in economics and
in other sciences never ends. At any given point in time we think of principles as the best available statement s of causal
relationships; however, additional data and better testing techniques may enable us to improve on them over time. Eco-
nomic theory is not a once-and-for-all set of principles. It is continually evolving and growing.

The Functions of Economic Theory

The principal functions of economic theory fall into two categories: (1) to explain the nature of economic activity
and (2) to predict 'what will happen to the economy as facts change. The explanation of the nature of economic activity
enables us to understand the economic environment in which we live how one part relates to others and what causes
what. We would also like to be able to predict with some degree of* accuracy what is likely to happen to the key
variables that affect our well-being and to be able to do something about them if we dislike the predicted consequences.
 Economists differentiate between positive economics and normative economics on the basis of whether the
users of theory are concerned with causal relationships only or whether the users of theory are concerned w i t h casual
relationships only or whether they intend some kind of intervention in economic activity to later the course of that
activity. Positive economics is supposed to be completely objective, limited to the cause- and-effect relationships of
economic activity; it is concerned with the way economic relationships are. By way of contract, normative economics is
concerned with what to ought to be. Value judgments must necessarily be made; that is, possible objectives to be
achieved must be ranked, and choices must be made among those objectives. Economic policy-making conscious
intervention in economic activity with the intent of altering the course that it 'will take is essentially normative in
character. But if economic policy-making is to be effective in improving economic well-being, it must obviously be
rooted in sound positive economic analysis. Policymakers should be cognizant of the full range of consequences of the
policies they recommend.

PRICE THEORY AND ECONOMIC THEORY

Price theory (microeconomic theory) and the theory of the economy as a whole (macroeconomic theory)
constitute the basic analytical tool kit of tine discipline of economics. The principles of both are applied to special
subject areas such as monetary economics, international trade and finance, public finance, manpower economics,
agricultural economics, regional economics, and so on. Both parts of the kit are essential to a thorough understanding of
economic activity.
Microeconomics is concerned primarily with the market activities on individual economic units such as consumers,
resource owners, and business firms. It is concerned with the flow of goods and services from business firms to
consumers, the composition of the flow, and the process for establishing the relative prices of" the component parts of
the flow. It is concerned too with the flow of resources (or their services) from resource owners to business firms, "with
their evaluation, and with their allocation among alter-native uses.
Macroeconomics treats the economic system as a whole rather than treating the individual economic units of which
it is composed. The particular goods and services making up the flow from business firms to consumers are not- integral
part of the analysis, nor are the individual resources or services moving from resource owners to business firms. The
value of the overall flow' of goods (net national product) and the value of the overall flow of resources (national income)
receive the focus of attention.
Price index numbers or general price level concepts in macroeconomics replace the relative-price concepts for
individual goods used in microeconomics. Macroeconomics concentrates on the causes of change in aggregate money
flows, the aggregate movement of goods and services, and the general employment level resources. Prescription of cures
for economic fluctuations and for unemployment of resources follows logically from the determination of the causes.
Macroeconomics has much to say about the nature of economic grown and the conditions necessary for the expansion of
productive capacity and national income over time.
Price theory is abstract because it does not and cannot compass all the economic data of the real world. To take
all of the factors that influence economic decisions of consumers, resource owners, and business firms into
consideration would require minute descriptions and analysis of every economic unit existence an impossible task. The
function of theory is to single out what appear to be the most relevant data and to build an overall conceptual
framework of the price system in operation from, these. We concentrate on the data and principles that seem to be
most important in motivating most economic units. In eliminating less important data and in building up a logical
theoretical structure, we lose some contact with, reality. However, we gain in our understanding of the overall operation
of the economy, because we reduce the factors to be considered to manageable proportions. We may sight of some
individual trees, but we gain more understanding and a better view of the forest. The end-of- chapter applications in this
book show how this process works.
The set of principles comprising price theory should show the directions in which economic units tend to move and
should explain the more important reasons why they move in that directions. They should be sets of logically consistent
approximations of how the economy operates. The abstraction and precision of theory are essential to clear thinking
and to policy-making in the real world, but we should guard against the notion that it provides an unqualified description
of reality. Theory should be the tool, not the master. Our ultimate goal is not the theory itself but a better understanding
of the economic society in which we live, along with the ability to use and apply the theory in a policy- making context to
push it toward what we want it to be.
Characteristics of Microeconomics
As mentioned earlier, microeconomics is concerned with the process of resource allocation by individual
decision units or markets. It is also concerned with efficiency with which these resources are allocated. From this
definition, some characteristics can be deduced. Among them are:
1. Microeconomics looks at the decisions of individual units. It focuses on the choices made by individual decision
units such as households, producers, and firms. Resource allocation decisions are made by these individual
entities in a market economy. It is necessary to understand their decisions in order to understand the economic
system.
Among the relevant questions that can be asked are: How efficiently are we using our resources? Could we be
more productive if we reorganize the ways of using them?
2. Microeconomics, often called price theory, looks at how prices are determined in various types of market
structures such as pure competition, monopoly, monopolistic competition, and oligopoly.
Among the relevant questions that can be asked with regard to these characteristics are: Should a monopolist
increase his price? Should a producer in an oligopolistic market lower his price? Can a producer under a purely
competitive market increase his price?
3. Microeconomics is concerned with social welfare. It, examines the efficiency, relative desirability, and choice of
alternative methods by which resources are utilized to alleviate scarcity. This branch of microeconomics is termed
“welfare economics.”
Among the relevant questions that can be asked are: Is it prudent to build a new bridge or to buy additional arms
for the army? Is it wise to impose price control? Should the government limit the controlling interests in media?
4. Microeconomics has a limited focus. Microeconomics is just a part of the economics discipline. It does not
examine the processes or efficiency of allocation in alternative types of economic systems, such as a socialistic
planned economy. Neither does microeconomics focus on other economic issues, such as aggregate level of
employment of resources or the rate of inflation. Problems dealing with the aggregate economy are within the
domain of macroeconomics.
5. Microeconomics develops skills. The study of microeconomics helps develop a set of useful and marketable skills
as follows:
a. Microeconomics helps develop logical reasoning.
b. Microeconomics helps develop skill in the construction and use of models. This is one of the major skills
economists teach to the business community.
c. Microeconomics employs optimizing techniques that are useful for making decisions in a variety of
situations.
d. The concepts studied in microeconomics are applicable to personal resource allocation decisions, such as
career choices or financial investments.

Economic Models
Microeconomics makes extensive use of modeling, comparative statics, and mathematics. Economic models are
composed of a series of statements of assumptions or given and statements or implications or deductions. The
statements described the essential features of an item or process and the interrelationships between the factors or
variables in the model.
Among the best known economic model is that of a competitive market, or “supply and demand”. The supply and
demand situations developed and explained in economics text are actually examples of economic models. The market
model is an example of comparative static analysis.
The supply and demand relationships could be expressed in three different forms: verbal (or logical)
mathematical and graphical. Let us illustrate by using the “Law of Supply”.
Verbally, the Law of Supply can be expressed in the following words: Supply is a schedule of prices and quantities
that a supplier or suppliers would be willing to offer for sale at each price per period of time. As suppliers, they would be
encouraged to sell more at higher prices and would sell less at lower prices. This is because higher prices, other things
being constant, mean higher profits, and lower prices mean lower profits. Thus, prices and quantity offered for sale are
directly related, i.e. the higher the price, the more supply; the lower the price, the less supply.
The verbal explanation of the law of supply can be expressed in mathematical notations. Mathematical notations
are merely shortcut representations of verbal explanations. The abovementioned law of supply can be expressed
succinctly in an equation:
 Qs = 500P

The equation Qs = 500P means that if the price is, say, P1 quantity supplied (Qs) would be P500 (500 x 1 = 500);
if the price is P3 quantity supplied would be P 1,500 (P500 x 3 = PI,500); if the price is P6, quantity supplied would be
P3,000 (P500 x 6 = P3,000). Thus we see that there is a direct relationship between price and quantity supplied explain
verbally in the aforementioned paragraph.
The law of supply can also be expressed graphically. If we compute the supply schedule as expressed in the
equation, Qs= 500P, we will have the following table;

Models are abstractions

As can be seen from, our discussion, a common feature of all models is that they focus only on the essential
elements of an object or process. In our example, we analyzed the behavior of supply only from the point of view of
varying prices. We mentioned that if prices are low, Quantity supplied would also be low; if prices are high, quantity
supplied would also be high. Of course, we know that supplies of commodities are also affected by other factors. Let us
leave the discussion in future chapters.

Price Quantity Supplied

1 P 500
2 1000
3 1500
4 2000
5 2500
6 3000
The above mentioned table can be expressed in the following graph:
Price

Definition of Economics
Economics Defined - Economics is the study of the ALLOCATION of SCARCE resources to meet UNLIMITED human
wants.

Division of Economics
a. Microeconomics - is concerned with decision-making by individual economic agents such as firms and
consumers. (Subject matter of this course)
b. Macroeconomics - is concerned with the aggregate performance of the entire economic system.
(Subject matter of the following course)
An Overview of the Economy

Goods and Services

Economic Resources

Household Business firm

Money Payment for Wages

Interest, Rent

Consumption Expenditure
Basic Economic Problems
1.What to produce?
2.How to produce?
3.How much to produce?
4.For whom to produce?

Types of economic System

1.traditional economic system- production decision is based on customs and traditions
2.command economy- answer to economic problems are dictated by the government
3.market system- deals with the economic, problems by considering consumer’s choice

Exercises:
1.Make a list of things you wanted to buy but cannot afford. What are the factors limit the items you wish to
purchase?
2.Name some products in the Philippines whose prices are determined by the government/ market.