Chapter 6

Theory of Production and Cost


1. Production and Production Function c. Long-run Period
• Production - a process that involves the combination and • Time is so long that the firms have enough time to change
transformation of inputs into a finished products.
the quantity of L,L,C,E

• Factors of Production (Inputs, dependent variable) —> Finished • All the inputs used in production are variable inputs and
Products (output, independent variable)
able to increase all inputs by a bigger proportion

• Production Function - Shows a technical relationship between • Combining all variable factors

the firms inputs and its outputs.

• VARIABLE FACTOR = L,L,C,E

- Output = f(Inputs)

- Q (amount of output produced) = f(L,L,C,E) <— factors of 2.1. 3 ways to measure Quantity
production
- Total product (TP)
- To increase the quantity of output —> the amount of input of • is the total quantity, or total output, of a particular good or
factors of production must also be increase service produced.

• Variable Inputs/Factors • Total amount of output able to produced with given set of
- inputs whose quantities can readily be changed like labor resources

and raw materials.

- Average product (AP),

- Easy to increase if you want to increase your output

• Total product per unit of the variable input

• Fixed Inputs • is output per unit of labor input

- inputs whose quantity is not changed by the firm, regardless • Measures the productivity of labor

of its reason
• Must be positive, negative denotes changes which is
- Very hard to change as output changes marginal (labor that produces -2 units doesn’t make sense)

• If AP=0, factors are: holiday, malfunction in equipment, no

2. Production Periods or Market Periods in Economics electricity, on strike/protest and such.

a. Very Short-run period or Immediate Period • AP = TP/VF ;(SRVF=Labor)

- The period are so short that all factors of production used by - TP = Total Product

the firm are fixed inputs

- VF = Qty. of variable factor

- Combining all fixed factors

- Interpretation: TP=200 pandesal, VF=2 panaderos
- Fixed Factor - L,L,C,E
• For 2 panaderos producing 200 pandesal, each
b. Short-run Period (SR) panadero can produce 100 pandesal
- Some inputs used by firm are fixed while others are variable
- Marginal product (MP)

- Change the quantity of factor that can be easily change

• Change in total product brought about by the change in
- Combining variable factors and fixed factors
variable factor

- MOST VARIABLE FACTOR - Labor

• Can be positive or negative, Equate to change (may
- Fixed Factor - Land, Capital, Entrepreneurial Ability
increase/decrease)

• Additional or extra product contributed by the last worker

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 - is the extra output or added product associated with adding b. The Stage of Decreasing/Diminishing Marginal Returns
a unit of a variable resource, in this case labor, to the • Producer continuously employs more labor input to a fixed
production process. Thus,
land, total product continuously increases but at a
- MP = △TP/△VF (SRVF= Labor Inputs) decreasing rate ( increasing slowly) until it reaches the
• Interpretation: 250 pandesal for 3 panadero TP1=200, maximum production level

VF1=2; M=50 • Both AP and MP are decreasing but AP > MP

- Adding 1 panadero increased the productivity by 50 • Stage where the producer has fully utilized the fixed
pandesal resources.

• Interpretation: 250 pandesal for 4 panadero; MP=0 • The rational stage of production

- Hiring of 4th panadero did not contribute to the • When there is no change in total product, MP is zero

c. The Stage of Negative Marginal Returns

production. ∴ 250 pandesal is the maximum quantity
- -MP = decrease in MP, +MP = there is contribution

• Stage of over-utilization of the fixed input

- the slope of the total-product curve

• As labor input increases, total product produced is now

decreasing so contribution of the added labor input (MP) is
- Guide in determining the stages and is the best way to already negative

measure the performance

• To increase the output, Labor must be decrease to avoid

3. The Law of Diminishing Marginal Returns SNR

• States that as successive units of variable inputs are added to

fixed inputs, total product increases at an increasing rate (I), Interpretation of TPL, APL, MPL per stage
continuously increases at a decreasing rate (II) and at a certain - At first, no output produced because there are no laborers
point total product declines (III)
utlilizing the fixed capital

• assumes that technology is fixed and thus the techniques of

production do not change.
Stage TPL APL MPL
• For example, if additional workers are hired to work with a
constant amount of capital equipment, output will eventually I TP will also increase AP is also MP is increasing
rise by smaller and smaller amounts as more workers are hired.
at an increasing rate increasing

4. The Three Stages of Production II Continue to increase since TP reaches its Decreasing and
a. The Stage of Increasing Marginal Returns but at decreasing rate maximum, once TP reaches
until It reaches its additional laborers its maximum,
• Any addition in variable input used, TP increases at an
increasing rate
maximum when there will cause less MP=0
is no change in TP productivity, AP
• Production level is not yet efficient because this is a stage
of under utilization of the fixed input (kaya pabilis ng decreases
pabilis ang paglaki)
III Already reached its AP also decreases TP decreases so
• Both AP and MP are increasing but MP > AP
maximum and will start the MP became
to decrease negative

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 Stage TPL APL MPL

TP & AP continue to decrease because

there’s too much labor utilizing a fixed capital
resulting to a decrease in output

Sample situation:

• If a shop hired just one or two workers, total output and productivity
(output per worker) would be very low. The workers would have to
perform many different jobs, and the advantages of specialization
would not be realized. Time would be lost in switching from one job to
another, and machines would stand idle much of the time. In short, the
plant would be understaffed, and production would be inefficient
because there would be too much capital relative to the amount of
labor.
• Total output would increase at a diminishing rate because, given the
fixed size of the plant, each worker would have less capital equipment - Short-Run Production Curve (Fig. In next page)
to work with as more and more labor was hired. The marginal product
of additional workers would decline because there would be more • TP

labor in proportion to the fixed amount of capital. - Behavior: upward and downward sloping

• Eventually, adding still more workers would cause so much congestion - start from the pt. of origin because no laborer will utilize the
that marginal product would become negative and total product would input

decline. At the extreme, the addition of more and more labor would • MP

exhaust all the standing room, and total product would fall to zero. - behavior: increase, decrease, then became negative

- Measures the rate of change of the Total Product

- Shows the contribution of the last laborer that was employed

- Short-Run Production Schedule - When TP is ↑ at decreasing rate, MP will ↓

• Labor-Capital Ratio (L/K): Given that the FF is Constant with • AP

increasing VF, more labor(VF) is utilizing your capital

• If AP ↑, MP is above AP

• SIR ends and SDR start If the increase in TP is slow and stops
increasing at an increasing rate
• If AP ↓, MP is below AP

• AP still have value even if MP=0 because MP measures the

exact no. of output that a specific laborer produce while the AP
average it so it is assumed that every laborer have equal
contribution in the production

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 4.1. Returns to Scale of Long-Run Period
- Measures the scale of plant

- the quantitative change in output of a firm resulting from a

proportionate increase in all inputs

• Increasing Returns to Scale (IRS)

- An increase in all inputs will lead to greater than proportional
increase in output (2x ↑ in input = 4x ↑ in output)

- good relationship of the firm w/ the employees

• Constant Returns to Scale (CRS)

- An increase in all inputs will lead to same proportional
increase in output (2x↑ in input=2x↑ in output)

- Firms are already adjusted

• Decreasing Returns to Scale (DRS)

- An increase in all inputs will lead to lesser than proportional
increase in output (2x↑ in input = 1x ↑ in output)

- labor management problem occurs and industrial strikes can

happen

5. Cost Function and Economic Cost

a. Cost Funtion
- C = f(factor payment)
- C = f(wages, rent, interest, normal profit)
b. Economic Cost and Accounting Cost
• Economic Cost - payment for the inputs that the firm uses in
the production process

• Accounting Cost - involves actual payment, if the factor owner

is not the producer, sum of all explicit cost only
• Opportunity Cost - measures things that must be given up or
sacrificed when one chooses one alternative over the other
c. Explicit Cost vs Implicit Cost
• Explicit Cost (revealed and expressed)
- monetary expenditures paid to outsiders who supply the
inputs
• Implicit Cost (present but not obvious)
- are the opportunity cost of self-owned or self-employed
resources

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 - money payments that self-employed resources could have - Cause of total cost to change

earned in their best alternative use.

- No variable cost if output is zero, ∴ it starts from the point of
- No actual payment
origin

- Sum of all variable cost: it increases as output increases,

hence TVC curve is upward sloping

• (TC) Total Cost

- Sum of total fixed costs and total variable costs

- TC is equal to TFC if TVC is zero

- Equidistant to TVC to show the TFC

- Market Period: TC=TFC

- Short-Run Period: TC=TFC+TVC

- Long-Run Period: TC=TVC

• Graph

d. Total Fixed Cost, Total Variable Cost and Total Cost

• Fixed Cost
- Payment for fixed inputs

- incurred at all levels of output, including zero.

- The firm cannot avoid paying fixed costs in the short run.

- Do not vary with output like rentals, depreciation —

allowance for wear & tear and obsolescence of capital

• Variable Cost

- Payment for variable inputs

- Vary directly with output like costs of labor and raw materials

• (TFC) Total Fixed Cost

- Sum of all fixed costs, constant and thus, curve is a
horizontal line

- Amount would be the same even if output is zero, one unit or e. Average Fixed Cost, Average Variable Cost, Average
one million units.
Total Cost and Marginal Cost
- Starts at the positive y-intercept (horizontal)
- Average fixed, average variable, and average total costs are
• (TVC) Total Variable Cost fixed, variable, and total costs per unit of output; marginal
- TVC is rising as more output is produced and falling as less is cost is the extra cost of producing one more unit of output.

produced

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 • (AFC) Average Fixed Cost = TFC/Q • (MC) Marginal Cost = △TC/△Q
- Fixed cost per unit of the product
- extra, or additional, cost of producing one more unit of
- Declines as output increases
output.

- downward sloping to the right

- First declines then continuously rises as output is increased

- A rectangular hyperbola (paliit lang paliit)

- The slope of Total Cost

- Asymptotic curve along the horizontal axis (y-axis)

- J-shaped curve

- The distance between ATC & AVC in the graph

- Cost Curve
• (AVC) Average Variable Cost = TVC/Q
- TVC per unit of output

- Initially decreases, reaches a minimum and rises as output

expands

- U shaped curve

• (ATC) Average Total Cost

- ATC=TFC/Q + TVC/Q = AFC+TVC

- Decreases as output increases, reaches minimum then

increases.

- Sum of the averages (AFC and AVC)

- U shaped curve

- Graphically, ATC can be found by adding vertically the AFC

and AVC curves, as in Figure 8.4. Thus the vertical distance
between the ATC and AVC curves measures AFC at any level
of output.

• ATC curve
- ATC curve is the first one to reach the minimum point
(intersects MC) than ATC because AFC is decreasing and it
influences the behavior of ATC, therefore it will be the last to
reach the minimum point

- ATC starts to increase because the decrease in AFC is only

-
minimal and do not affect the ATC anymore

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 • MC Curve
- Going downwards because AFC and AVC are decreasing f. Production Costs in the Long-Run
(downwards)
- The firm can alter its plant capacity, it can build a larger plant
- Going up because ATC starts to increase as output increases or revert to a smaller plant

because of the increase in average cost

- can undertake all desired resource adjustments.

- MC is Decreasing at first because the additional increase in - can change its overall capacity; the long run allows sufficient
output is increasing and because MP is increasing
time for new firms to enter or for existing firms to leave an
- MC then starts to increase because MP is decreasing
industry.

• The space between ATC and AVC is getting smaller because - Long-Run ATC curve

AFC is getting smaller

• U-haped but less U

• Relationship of MC and ATC • envelope of the Short-run Average Cost (SRAC)

- The marginal-cost curve intersects the average-total-cost - Represents various plant sizes a firm is able to operate

curve at the ATC curve’s minimum point. • Also called Planning Curve

• Best scale of plant because more output produced at • the long-run ATC curve for the enterprise is made up of
lowest cost
segments of the short-run ATC curves for the various plant
- as long as MC lies below ATC, ATC will fall, and whenever sizes that can be constructed.

MC lies above ATC, ATC will rise.

• The long-run ATC curve shows the lowest average total
- ATC↑, MC is above ATC If ATC ↓, MC is below ATC
cost at which any output level can be produced after the
- Therefore, at the point of intersection where MC equals ATC, firm has had time to make all appropriate adjustments in
ATC has just ceased to fall but has not yet begun to rise.
its plant size. the lowest ATC is the Optimum Scale of
Plant — lowest possible cost at highest possible quantity

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 g. Economies and Diseconomies of Scale
• the U shape in long-run ATC curve is caused by
economies and diseconomies of large- scale production
Chapter 7
• Economies of Scale
- Exists when long-run average costs decline as output rises Market Structure

and larger firms will be more efficient than smaller firms

- economies of mass production, explain the downsloping part 1. average, total and marginal revenue

of the long-run ATC curve.

a. Total Revenue
- As plant size increases, a number of factors will for a time • The total revenue for each sales level is found by
lead to lower average costs of production.
multiplying price by the corresponding quantity the firm
- consequence of greater specialization of labor and can sell. (TR = P X Q)

management, more efficient capital

• If a producer produce x units at a price of P, the revenue he
- equipment, and the spreading of start-up costs among more will get is TR

units of output.
• Interpretation: P=12; Q=2; TR=24

• Diseconomies of Scale - if the seller produce 2 units and he sells it at the price of
- Said to exist in the range where average cost rise with P12 per unit, he will recieve a total of P24
increase in output
b. Average Revenue
- Emerge because managerial skills have reached the point of • also the firm’s demand schedule (demand curve).

diminishing returns
• Price per unit to the purchaser is also revenue per unit, or
- difficulty of efficiently controlling and coordinating a firm’s average revenue, to the seller.

operations as it becomes a large-scale producer.

• AR = TR/Q, ∴ AR = P = TR/Q (except when Q=0)

- caused by the problems of coordination and communication • for each unit of output sold, the revenue received is AR (x)

that arise in large firms.

• Interpretation: P=10 Q=3; AR=10

- If the producer sells 3 output at the price of P30, he will

gain P10 Fromm each of the 3 output

c. Marginal revenue

• The additional or extra revenue from an additional unit of

output

• the change in total revenue (or the extra revenue) that

results from selling one more unit of output. In pure
competition, marginal revenue and price are equal.

• Can be positive or negative

• MR = △TR/△Q

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 d. Revenue Curve • Behavior

- TR ↑; MR>0
- TR — ; MR=0
- TR ↓ ; MR<0
• Elasticity

- |-εp|>1 ; demand is elastic; TR ↑ when P ↓

- |-εp|=1 ; demand is unitary; TR —

- |-εp|<1; demand is inelastic; TR ↓ whenP ↓

2. Two Approached to Profit Maximization and Loss

Minimization

• *Invisibile Hand

- Self-interest of every economic unit

• Maximizing the satisfaction

• To maximize profit for businesses

• Total Revenue - Total Cost

- Economic Profit = TR-TC
- Maximum profit is the biggest difference between Total
Revenue and Total Cost

TR<TC Tπ < 0 Economic Loss (-Tπ)

TR=TC Tπ=0 break-even (Normal Profit in TC)

TR ↑; MR>0
TR>TC Tπ > 0 Economic profit
TR—; MR=0 TR ↓ ; MR<0

9

MR>MC Mπ > 0 Marginal profit Tπ ↑ (still increasing)

MR=MC Mπ = 0 Marginal break-even Tπ —

MR<MC Mπ < 0 Marginal Loss Tπ ↓

• MR=MC is the Maximum profit because the Tπ will not

increase anymore, ∴ Tπ is already maximum

3. Industry and Firm and Market Structure

Market - more of a situation where buyers and sellers meet and
transactions take place

• Marginal Revenue - Marginal Cost Approach Industry - group of firms selling the same product (e.g. agriculture
- compares the amounts that each additional unit of output industry, manufacturing industry)

would add to total revenue and to total cost.

Firm - single seller/producer/company (e.g. sari-sari store, big
- In the short run, the firm will maximize profit or minimize loss corporation)

by producing the output at which marginal revenue equals

marginal cost (as long as producing is preferable to shut- ting
down) —> MR=MC
- Marginal is more accurate in economic if the change is
analyzed

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Market Structure
- Profit Maximizing Condition in Pure Competition:
- Pure or Perfect Market
Best Condition in gaining economic profit
• Pure of perfect competition
P=MC; P>AVC; P>ATC

• Pure Monopoly

- Imperfect Markets

• Monopolistic competition - combination of two perf markets

• Oligopoly - combination of two perfect markets but closer to

monopoly

4. Pure competition
- involves a very large number of firms producing a standardized
product (that is, a product identical to that of other producers,
such as cotton or cucumbers). New firms can enter or exit the
industry very easily.

- Demand curve for the industry and the firm under Pure
Competition
• Demand curve is also call the AR curve

• AR curve is also the MR curve because the firm sells at the

same price

• The point of maximum π is MR=MC but specifically at P=MC

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 -Minimum - Break-even
Condition P=MC;

P=MC; P>AVC; price is above the AVC

P=AVC; or > P=ATC; price is at the minimum point of ATC

P<ATC;
no loss, just normal profit

Loss: FC only
- Optimum scale of Prod for Long-Run:
• P=LRMR=LRMC

• P=LRAC=SRAC

• Normal profit only because new firms are entering in the

industry so P=LRAC

• Profit will decrease if new firm enter ∴ TC=TR

Output Determination in Pure competition in SR

Question Answer

Should this firm Yes, if price is ≥ minimum AVC. This

produce? means that the firm is profitable or that its
losses are less than its fixed cost.
- Have to shut What quantity should Produce where MR (= P) = MC; there,
down this firm produce? profit is maximized (TR exceeds TC by a
condition maximum amount) or loss is minimized.
P=MC;
P<AVC; Will production result Yes, if price exceeds average total cost
P<ATC;
in economic profit? (TR will exceed TC). No, if average total
Loss: All FC cost exceeds price (TC will exceed TR).
and some VC

5. Pure monopoly
- is a market structure in which one firm is the sole seller of a
product or service (for example, a local electric utility). Since the
entry of additional firms is blocked, one firm constitutes the entire
indus- try. The pure monopolist produces a single unique product,
so product differentiation is not an issue.

- Demand Curve
• AR and MR is different because the price is increasing and
decreasing because of the Monopoly Power —ability of the
producer or of the firm to control the price

• D curve depicts the price

12
 -Profit 6. Monopolistic competition
Maximizing - is characterized by a relatively large number of sellers producing
Condition differentiated products (clothing, furniture, books). Present in this
•MR=MC;
model is widespread non-price competition, a selling strategy in
•P>ATC
which one firm tries to distinguish its product or service from all
competing products on the basis of at- tributes like design and
workmanship (an approach called product differentiation). Either
entry to or exit from monopolistically competitive industries is
quite easy.

- Demand Curve
- Long-Run
• In the long run, firms will enter a profitable monopolistically
competitive industry and leave an unprofitable one. So a
monopolistic competitor will earn only a normal profit in the
long run or, in other words, will only break even. (Remember
that the cost curves include both explicit and implicit costs,
including a normal profit.)

- Minimum - Predatory pricing - lowering the price when a new firm enter
Condition
•P>AVC

•P<ATC

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 Possible cause of Mutual Interdependence

- Collusion
• cooperation with rivals; price of one, price of all

• occurs whenever firms in an industry reach an agreement to fix

prices, divide up the market, or otherwise restrict competition
among themselves. The disadvantages and uncertainties of
noncollusive, kinked-demand oligopolies are obvious. There is
always the danger of a price war breaking out, especially during
a general business recession.

- Cartel - an association of manufacturers or suppliers with the

purpose of maintaining prices at a high level and restricting
competition:
- Price war - result for two competitors, both will experience loss
and to prevent this, they will just talk to each other/agreement

- The kinked demand curve of the oligopoly

• demand above the kink is elastic

• Demand below the kink is inelastic

7. Oligopoly
- involves only a few sellers of a standardized or differentiated
product, so each firm is affected by the decisions of its rivals and
must take those decisions into account in determining its own
price and output.

- Rigid price - price that difficult to change

• If the firm raises its price, it does not expect competitors to go
along and it sees elastic market demand; buyer’s will likely
substitute competitor’s cheaper goods and the firm will lose
market share

• consumers will be distributed with same prices as competitors

will also decrease the price if you decrease the price. If the firm
lowers its price, demand increases but not as much the
percentage decrease in price due to inelastic demand

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 Characteristics of the Four Structures of Market

Pure or Perfect Market Imperfect Market

Characteristics Pure Competition Pure Monopoly Monopolistic Competition Oligoply

Sellers Large number of buyers and sellers - One seller - the firm is the Sufficiently large number of sellers Few sellers
industry itself (compe)

Type of Product Homogenous (identical/same) or Unique Identical (compe) but differentiated Can be homogenous or identical
standardized product (mono) products but differentiated

Control over the No Control:
 Full Control:
 Some/Limited control:
 Limited by mutual
price -Copies price of another firm (price Price setter/price maker - price Non-price competition!!
 interdependence* -base their
taker/price imitator)
 discrimination occurs - control over the price (mono) decisions on how they think rivals
-It cannot change market price; it can will react. and considerable with
only adjust to it. collusion*

Entry and Exit Freedom of entry exit and exit - new Monopolist creates barriers to Relatively Easy entry & exit (compe) Difficult to enter (significant
firms can freely enter and exit entry (blocked entry) obstacles)

Substitute Perfect substitute No close substitute Parital substitute

Demand Curve Perfectly elastic relatively inelastic
 highly elastic demand - 
 Kinked Curve

Downward sloping - demand Downward sloping (too many partial oligopoly - elastic

competition) complete oligopoly - relatively
inelasitic

Non-price none Public relations advertising Emphasis on advertising, brand Advantage for product
competition names, trademarks differentiation

examples Fruits and vegetables water, electricity, trains soaps, shoes, dresses gasoline, car industry

Add info: -in a purely competitive industry, there -Monopsy - single buyer
 Monopolistic competition is more -duo-poly - 2 sellers

is a large number of competitive firm
 -Barriers
 competitive than oligoply
 - Homogenous/pure/complete
Perfect competition - if buyers and - patents (intellectual property - the more seller, the higher the oligopoly - homogenous
sellers have complete knowledge or rights)
 competition
 products (crude oils from diff
access to information. e.g. stock - franchises
 Non-price competition - countries)

market
 - all raw materials are owned by competition in terms of product -differentiated/partial oligopoly
-nearest homogenous products are agri the producers
 differentiation
 - refined oil industry (petron, shell)

products - state monopolies -Branding and packaging
 - Mutual interdependence-each
- location
 firm’s profit depends not entirely
- service
 on its own price and sales
- heavy advertising strategies but also on those of the
other firms.
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III. Macroeconomics
Macroeconomics
- Big branch of economics that studies the
behaviour of the aggregate economy or the
economy as a whole

• aggregate: a whole formed by combining

several separate elements:

- The General Theory of Employment, Interest

and Money” (1936) by John Maynard
Keynes — Father of Macroeconomics

- Inflation is an increase in the overall level of

prices.

- Savings are generated when current

consumption is less than current output (or
when current spending is less than current
income).

- Investment happens when resources are

devoted to increasing future output

- Stabilization Policies
• Monetary Policy
- Interest Rate

- Money Supply

• Fiscal Policy
- Government expenditures

- Taxes

Leakages = Injections (leakages and its

corresponding injections)
- Savings = investment

- Taxes = government purchases

- Imports = exports

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Chapter 8 - Three Approaches in Estimating Gross Domestic Product

1. Final Expenditure Approach

Measuring National income and Output
2. Factor Income Approach
- gross domestic product, 3. Value added from Industrial-Origin Approach
• measures the total market value of final goods and services
produced within the economy or borders of a given country 1. Final Expenditure Approach
during a given period of time, typically a year.
• Sum of all types of expenditures on final goods and services
- Current GDP or “nominal” GDP at Current prices from the four sectors in the economy

• Also called Money GNP/GDP

- MODEL: GDP = C + I + G + (X—M)
• Unadjusted GDP — uses the price of current year which is - add:
higher than the past year

• Measures the market value of final goods and services
produced in the economy at prices prevailing in that period
expenditure represent almost all purchase by households of
• NGDP/NGNP = εpnqn
• (C) Household Final consumption Expenditure. The
durable consumer goods, non-durable consumer goods, and
consumer expenditures for services

- pn price of a good for current year

- qn quantity of goods produced for the current year

• (I) Investment or the Capital Formation. Two components are:
a) Fixed Capital

- Real GDP or GDP at Constant Prices b) Change in inventories

• Aka deflated (smaller than the current prices)

• (G) Government Consumption Expenditures. Includes all
• Measures the market value of produced output in the economy governmental spending on the finished products of business, all
at prices in the base period. Hence removing the effect of
direct purchase of resources by government

inflation or deflation

• Better measure in determining economy’s performance • (X-M) Net Exports. The differences between exports and
because its changes are due to an increase in production in the imports of goods and services.

economy not by change in prices

- add: Statistical Discrepancy NIPA accountants add a statistical
discrepancy to national income to make the income approach
• RGDP/RGNP = εpoqn match the outcome of the expenditures approach.

- po price of a good in its base year

- Equals: GDP

- qn quantity of goods produced for the current year

- add: Net Primary Income/Net Factor Income. Income the
• Real GDP = Current or NGDP/Price Deflator (CPI) x 100 citizens gain from supplying resources abroad. It is the difference
between the aggregate flow of factor payments from the ROW
- Price Index (deflator) (e.g. salary remittances of Filipino working abroad.

• PI = εpnqn / εpoqn - equals: GNP

• PI = NGDP/RGDP X 100
- General Price Level - price of all comodities

• >100 - when price is higher than past year price

• = 100 - GNP = GDP

• <100 - when price is lower than the price of the past year

- Per Capita RGDP = Real GDP/Population

17
2. Value added from Industrial-Origin Approach 3. Factor Income Approach
- Value-added from the 3 productive sector in terms of producing • Sum of all the income payments derived from the four factors of
output:
production (land, labor, capital, and entrepreneur) such as the
I. Primary Sector - Agricultural Sector
rent, wages, interest, and normal profit

• Hunting, Forestry, Fishing

- MODEL: Y = TR + TW + Ti + TP
II. Industry Sector
- add:

• Mining and Quarrying, Manufacturing…

• (TR) Rental Income. Income received by households and
III. Service Sector
businesses that supply property resources (condominiums and
apartments)

- contribution to each stage is the value added

• (TW) Compensation of Employee. Includes wages and

- MODEL: Y = total value-added of all productive sectors salaries paid to employees, also includes wage and salary
- add:
supplement, payments by employers into social insurance and
• GVA in agriculture, fishery, forestry into a variety of private pension, health, and welfare funds for
• GVA in Industry workers

- Mining
• (Ti) Interest. Money paid by private businesses to the suppliers
- Manufacturing (big contribution to Philippines and China)
of money capital (e.g. loans)

- Construction
• (TP) Normal Profit. Sum of proprietor and corporate’s profit

- Electricity, Gas, and Water Supply

- Entrepreneurial/Proprietor’s income. Consists of the net
• GVA in Service Sector income if sole proprietorships, partnerships and other
- Transport, storage and communication
unincorporated businesses

- Trade and repair of motor vehicles, motorcycles, personal - Corporate income. Earnings of owners of corporation

household goods
• Corporate income taxes

- Financial intermediation (Bank Services)

• Dividends —distribution of income to its stockholders

- Real Estate, Renting, & Business activities

• Undistributed corporate profit (retained profits) — savings
- Public administration, defense, social welfare (Government of a firm that goes to capital formation

Expenditures)
- Equals: National Income with Factor Cost

- Other services (professionals like lawyer and doctors)

- Less:

- Equals: GDP
• SSS Contributions

- Add: Net Primary Income

• Undistributed corporate profit

- Equals: GNI
- add:

• Dividends

• Transfer payments

- Equals: Personal Income —all income received, whether earned

or unearned.

- Less: Direct Taxes

- Equals: Personal Disposable Income

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Other National Accounts Transactions that are not part of National Income -
- Net National Product - productive non market activities which are excluded in GDP

• Simply GDP adjusted for depreciation of capital which the • Black Market

economy used
• Consumption of home grown food

• Net National Product (NNP) = GDP - CCA • Production in the Underground economies or the informal
• Where:
sector (sidewalk vendors, jeepneys, tricycle drivers)

- Capital Consumption Allowance (CCA) - sum of all • Housewife services

depreciation of all firms

- Expenditures excluded in GDP

- Net National Income • Second Hand Sales (ukay-ukay, vehicles)

- Accounting rule: credit the value once

• Net National Income (NNI) = NNP — IBT — subsidies - Not produced during the time of sale

• Where

- Indirect Business Taxes (IBT) - taxes on the sale of goods • Financial Transactions

- Public and Private Transfer Payments

and services. Includes the value added tax

- Stocks and Bonds

- National Income
• Debt repayment

• Measures the output produced at its factor cost

• Payment of government transfers such as pensions, grants and
• Total of all income earned by factors of production, it is the sum aid provided by donor agencies for social services.

of wages, rent, interests, and profit earned by the suppliers of

labor, land, capital and entrepreneurship

Shortcomings of GDP
• NY = GDP - (Net Primary Income + CCA + IBT) 1. Increase in leisure time has clearly a positive effect on overall
- Personal Income - national income less income not received by well-being. But the system of national income accounting
the individual such as the undistributed corporate profit and understates well-being by ignoring leisure’s value

corporation income tax and SSS/GSIS but add the income that is 2. Because GDP is a quantitative measure rather than a qualitative
received but not earned like transfer payments

measure, it fails to take into account the value of improvements

• PY = NY - (undistributed corporate profit + corporate in product quality
income tax + SSS/GSIS contribution) + (transfer payments)
3. The growth of GDP is inevitably accompanied by the social
- Personal Disposable Income
costs or the negative by-products of economic well-being.
• personal income less personal taxes. Personal taxes include Since those costs are not deducted from GDP it overstates our
personal income taxes, personal property taxes, and
national well-being

inheritance taxes.

4. Distribution of output may make big difference for society’s

• Disposable income is the amount of income that households overall well-being but not reflected in the measurement of GDP

have left over after paying their personal taxes.

• Can be derived by subtracting personal taxes from personal ———————————

income; PDY = PY - PT

• The amount that households have for personal consumption (C) (c) Vina and Chris’ Nota
and savings (S) is the personal disposable income

- PDY = C + S

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