APPLIED ECONOMICS

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Market Efficiency and the Gains from Exchange

 Market forces operate whether or not buyers or sellers understand the laws of demand and
supply.
 No individual or small group coordinates market activities.
 Market forces arise naturally without central coordination.

Measures of Efficiency
1. Productive Efficiency
- Occurs when a firm produces at the lowest possible cost per unit.
- The firms that thrive and survive in a competitive market are those that supply a good or a
service at the lowest cost.
- Competition ensures that firms produce at the lowest possible cost per unit.

2. Allocative Efficiency
- Occurs when firms produce the output that is most valued by customers.
- Producing a good or a service at the lowest possible cost per unit is not a guarantee that
firms are producing what consumers most prefer. Likewise, firms may be producing goods
efficiently but producing the wrong good or service.
- Market competition promotes both productive efficiency and allocative efficiency. This
can be known through the market demand and supply curves.

Allocative Efficiency
 The demand curve reflects the marginal benefit that
consumers attach to each unit of the good.
 On the other hand, the supply curve reflects the marginal MB = MC
cost of supplying the final unit sold.
 The supply and demand curves intersect (equilibrium) at
the combination of price and quantity at which the
marginal benefit that consumers attach to the final unit
purchased just equals the marginal cost of the resources
employed to produce that unit of good.
 The market is said to be allocatively efficient.

Market Demand and Consumer Surplus

 Consumer Surplus – the difference between the most that consumers are willing and able to
pay for a given quantity of a good and what they actually pay.
 Example: Based on the demand curve, consumers demand 8 million pizzas at a price of P150.
Consumers demand 14 million pizzas at a price of P120. At a price of P90, consumers demand
20 million pizzas.
  If the price is P90/pizza, consumers enjoy a surplus, or a bonus, because they get to buy all
20 million pizzas for P90 each, even though some are willing to pay more for lesser amounts.

Comparative Advantage and Specialization

 Individuals can get more things done by specializing and then trading with other specialists.
 The division of labor allows an economy to increase production by having each worker
specialize.
 Specialization occurs not only among individual workers, but also among firms, regions, and
entire countries.

COMPARATIVE ADVANTAGE ABSOLUTE ADVANTAGE

 The ability to produce or specialize in an  The ability to make something using fewer
output with the lowest opportunity cost. resources than other producers require.
 First developed by Adam Smith in 1776.
(The Wealth of Nations)

Sample Situation
1. Anna takes 45 minutes to wash a car and one hour to tend the garden. All in all she spends
two and a half hours a week to wash two cars and tend the garden. On the other hand,
David takes one hour to wash a car and three hours to tend the garden. Altogether, David
spends five hours a week on these tasks. Who has the absolute advantage on the two tasks?
 Anna has the absolute advantage because she uses fewer resources. The resource in the
situation is labor time.
The Law of Comparative Advantage
 States that the worker, firm, region, or country with the lowest opportunity cost of producing an
output should specialize in that output.
 First illustrated by David Ricardo in 1819 (On the Principles of Political Economy)
 Examples:
Washing the Car Tending the Garden
Anna 45 minutes 60 minutes
David 60 minutes 180 minutes
a. Who has the absolute advantage on the two tasks? Anna.
b. What is Anna’s opportunity cost of washing each car? of the garden. (In the 45 minutes Anna
takes to wash the car, she could instead mow three-fourths of the lawn.)

c. What is David’s opportunity cost of washing each car? of the garden. (In the 60 minutes
David takes to wash the car, he could instead mow one-third of the lawn.)

Days to Repaint One Car Days to Rebuild One Engine

Click 1½ 1
Clack 2 1½
a. Who has the absolute advantage on the two tasks? Click.
b. What is Click’s opportunity cost in rebuilding one engine? of repainting one car

c. What is Clack’s opportunity cost in rebuilding one engine? of repainting one car

Gains from Specialization

 Specialization – occurs when individual workers focus on single tasks, enabling each worker to
become more efficient and productive
 Each individual worker saves time through specialization and exchange.
 Barter – a system of exchange in which products are traded directly for other products.
 Division of Labor – organizes the production process so that each worker specializes in a
separate task.

Resource Markets
RESOURCE MARKETS DEFINITION
 Markets in which goods and services are
exchanged.
Product Markets (Output Markets)
 Where households are demanders and firms are
suppliers.
 Markets where resources – labor, capital, and land
Resource Markets (Input Markets) are used to produce products and are exchanged
 Households are suppliers and firms are demanders.
Market Demand for Resources
 Factors of Production: Land, Labor, Capital, Entrepreneurship
 Firms use these resources to produce goods and services
 A firm values not the resource itself but the resource’s ability to produce goods and services.
 Derived Demand – the demand for a resource that arises from the demand for the product
that resource produces.
 The demand for a carpenter arises, or derives, from the demand for the carpenter’s output
such as houses, buildings, etc.
 Demand for truck drivers arises from the demand for transportation of goods.
 The more a worker produces and the higher the price of that product, the more valuable the
worker is to a firm. Thus, the demand for a resource is tied to the value of the output produced
by that resource, or its productivity.
 Productivity – the value of output produced by a resource. The more productive a resource is,
the more a firm is willing to pay for it.

Demand Curve for a Resource

 Like a demand curve for a good or service, it is also sloping downward.
 As the price of a resource falls, firms are more willing and more able to
employ that resource.

Supply Curve for a Resource

 Sloping upward
 Resource suppliers are both willing and able to supply the resource as its
price increases

Demand and Supply for a Resource (Labor)

 The interaction of the resource demand curve (D) and the
resource supply (S) determines the equilibrium wage (W) for a
resource (labor) and the equilibrium employment (E).
 Equilibrium Wage – the wage at which the quantity of labor
firms demand exactly matches the quantity workers supply. At
this point, there is neither an excess quantity of a resource
(labor) demanded nor an excess quantity supplied.

Nonwage Determinants of Labor Demand

 The quantity of labor demanded increases as the wage decreases, vice versa, ceteris paribus.
 Causes a shift in the demand curve.
1. Demand for the Final Product
 Since the demand for labor is derived from the output
that labor produces, therefore any change in the
demand for that output affects labor demanded.
 Example: An increase in the demand for houses
increases the demand for carpenters.
 Demand curve for labor shifts to the right, D1 to D2.
 Market wage and employment are increased.
 2. Prices of Other Resources
 A change in the price of other resources could shift the demand for labor.
 Resource Substitutes – resource used to replace another resource in production.
 Resource Complements – resources that go together in production.
 Example: An increase in the cost of a bulldozer increases the
demand for laborers.
 Bulldozers replace the laborers (substitutes); when the
price of the bulldozer increases, construction companies
would prefer to employ laborers instead.
 Demand curve for labor shifts to the right, D1 to D2.
 Market wage and employment are increased.
 Example: If the cost of lumber increases, the quantity demanded for lumber decreases,
thereby decreases the demand for construction workers.
 Lumber would need to be processed by the laborers.
(Complements)
 An increase in the cost of a complement will decrease the
demand for its complement.
 Demand curve for labor shifts to the left, D1 to D2.
 Market wage and employment are decreased.

3. Technology
 A change in technology can shift the demand curve.
 An increase in the use of technology also increases the demand for labor.
 In other cases, improved technology could make laborers
unnecessary.
 Example: The use of artificial intelligence (humanlike machines)
in BPO industries.
 The demand curve for call center agents shifts to the left, D1
to D2.
 Market wage and employment are decreased.

Nonwage Determinants of Labor Supply

 The quantity of labor supplied increases as the wage rate increases, or vice versa, other things
are held constant.
1. Worker Wealth
 A person’s supply of labor depends on his or her wealth including financial assets,
properties, savings, etc.
 A decrease in wealth would prompt people to work more.
 An increase in wealth lets people to work less or even not at
all.
 Example: A stock market decline during the Global Financial
Crisis in 2008.
 Reduced the wealth that many people planned to draw
on during retirement.
 People will work more, thereby shifting the labor supply curve to the right.
 2. Working Conditions
 Supply of labor depends on the working conditions, such as
the difficulty of the job and the attractiveness of the work
environment.
 Example: Construction companies offer rigid work schedule.
 Supply of labor will decrease.
 Labor supply curve will shift to the left.
 Market wage will increase and employment will decrease.

3. Tastes for Work

 Job tastes are relatively stable.
 The supply of labor could change because of a change in the
taste for a particular job.
 Example: Carpentry becomes more appealing because
people become more attracted to jobs with great exercise,
satisfaction of building something, etc.
 Rightward shift of the labor supply curve.

Wage Determination
 Wages differ substantially across labor markets.
 Wages differ based on positions in a company, types of occupations, and geographical
locations.

1. Differences in Training, Education, Age, and Experience

 Some jobs pay more because they require a long and expensive training.
 Costly training reduces the supply of labor because fewer people are willing to undergo
the time and expense required.
 Examples:
a. Certified Public Accountants (CPA) earns more than file clerks because the
extensive training limits the labor supply, besides that CPAs are considered more
productive.
b. Brain surgeons earn twice as much as general practitioners.
 At every age, those with more education earn more. Among more educated workers,
earnings also increase as workers gain more job experience and become more
productive.

2. Differences in Ability
 Some workers earn more than others with the same training and education because
they have additional ability, more able, and more productive.

3. Differences in Risk
 Jobs with a higher probability of injury or death, such as coal mining and ocean fishing,
pay more than safer jobs, ceteris paribus.
 Examples:
a. Graveyard shift workers are entitled of night differential pay because they are at
high risk of heart attacks.
 b. Workers earn more in seasonal jobs such as construction and fishing.

4. Geographic Differences
 People have a strong incentive to supply their resources in the market where they earn
the most, ceteris paribus.
 Causes brain drain
 Example: Physicians earn more in the United States than in the Philippines, therefore
thousands of doctors migrate in the U.S. each year.

5. Job Discrimination
 Some people earn less because of discrimination in the job market based on race,
ethnicity, or gender.
 Example: An employer avoids hiring married females because they have the possibility
of getting pregnant, thus imposing more cost on the employer (i.e. maternity leave).

6. Union Membership
 Workers represented by labor unions earn more on average than other workers.
 Example: The USTFU gives cash incentives to faculty members who just finished their
master’s and doctorate degrees.

The Minimum Wage

 The Minimum Wage Law establishes an amount that an employee can pay a worker for one
day of labor.
 The current minimum wage in Metro Manila is P512 (with COLA – Cost of Living Allowance).

Effects of the Minimum Wage

 An increase in the minimum wage results to:
1. Substituting part time jobs for full-time jobs.
2. Substituting more qualified minimum wage workers for less qualified workers.
3. Adjusting some nonwage features of the job to reduce employer costs or increase worker
productivity.
 Non-wage Job Features:
a. Convenience of Work Hours f. Paid Vacation Days
b. Expected Work Effort g. Paid Holidays
c. On-the-Job Training h. Sick Leave Policy
d. Break time i. Policies for Arriving Late or
e. Wage Premiums for the Night Leaving Early
Shifts and Weekend j. Healthcare Benefits

Foreign Trade, Foreign Aid, and Economic Development

 Economic development can be described in different ways:
a. Shifting from agricultural products and raw materials to manufacturing more complex
products
b. An increase in a country’s income on a sustainable basis; income is transposed to a
sustained change (e.g. education, public infrastructure, healthcare service, etc.)
 No change in a country’s income = no economic development
Foreign Trade Strategies
1. Import Substitution
- a development strategy that emphasizes replacing imports with domestic production
- in this strategy, the packaging and even the name of the product were quite similar to the
imported good
- e.g. Havana-Havainas, Nike-Kine, Puma-Pamu, etc.
- To insulate the production of these domestic goods and protect it from foreign
competition, the governments impose the following trade restrictions:
a. high tariffs – tariff is simply a tax on imports which reduces the supply of imported goods
in the local market
b. stiff import quotas – import quota is a legal limit on the quantity of a particular product
that can be imported

2. Export Promotion
- a development strategy that focuses on producing for the export market
- has been the more successful development strategy of the newly industrialized Asian
Tigers (Taiwan, South Korea, Hong Kong, Singapore)

Pros of Foreign Trade

1. More Jobs
2. Wide Variety of Output
3. Increased Country’s Income
4. Diffusion of Knowledge and Skills

Cons of Foreign Trade

1. Excessive Use of Resources
2. Lax Trade Restrictions – Since job opportunities and salaries are far better in developed
economies, workers and professionals from developing countries move to richer countries
each year.
 Brain Drain – a developing country’s loss of educated migrants to industrial market
countries
3. International Migration
4. Vulnerability of Local Markets

Foreign Aid
 is any international transfer made on especially favorable terms, for the purposes of promoting
economic development (e.g. cash grants, cash loans, capital goods, technical advice, food,
etc.)
  Bilateral Aid – country-to-country aid
 Multilateral Aid – funds from a number of countries where collected by organizations such as
World Bank (WB), International Monetary Fund (IMF), U.S. Agency for International
Development (USAID), etc.

The Market for Foreign Exchange

 Foreign Exchange Market – involves all the arrangements used to carry out international
transactions.
 Foreign Exchange – is foreign money people need to carry out international transactions.
 Exchange Rate – the dollar price or purchasing a unit of another country; the price measured
in one country’s currency of purchasing one unit of another country’s currency.
 The exchange rate, like any other price, is determined by demand and supply. The equilibrium
price of foreign exchange is the one that equates quantity demanded and quantity supplied.

Graph for Foreign Exchange

 Horizontal Axis – shows the quantity of the foreign exchange (in millions per day)
 Vertical Axis – indicates the dollar price/ the exchange rate

The Demand for Foreign Exchange

 U.S. Residents need Euros to pay for goods and services from
the Eurozone; to buy assets from there, to make loans to the
Eurozone, or simply to send cash to friends or relatives there.
 The demand curve D for foreign exchange shows the
relationship between the dollar price of the euro and the
quantity of euros demanded.
 The lower the dollar price of foreign exchange, the
greater the quantity of foreign exchange demanded.
 The cheaper it is to buy euros, the lower the dollar price
of Eurozone products, so the greater the quantity of euros demanded by U.S. residents.

The Supply for Foreign Exchange

 The supply of foreign exchange is generated by the desire of
foreign residents to acquire dollars, that is, to exchange euros
for dollars.
 Residents of the Eurozone want dollars to buy U.S. goods
and services, to buy U.S. assets, to make loans in dollars, or
to send cash dollars to their U.S. friends and relatives.
 An increase in the dollar-per-euro exchange rate, ceteris
paribus, makes U.S. products cheaper for foreigners;
therefore, more euros will be supplied on the foreign
exchange market to buy dollars.

Determining the Exchange Rate

 An increase in the dollar price of a euro indicates a weakening of the dollar or dollar
depreciation. (applicable to other currencies)
  A decrease in the dollar price of euro indicates a
strengthening of the dollar or dollar appreciation.
(applicable to other currencies)
 Example: Assuming an increase in U.S. residents’ income
causes Americans to increase their demand for all
normal goods, including those from the Eurozone.
 An increase in U.S. residents’ income shifts the U.S.
demand curve for euros to the right, as Americans
seek euros to buy more German cars and European
vacations.
 The rightward shift of D to D1 to D2 increases the exchange rate from $1.30 to $1.32, thus
increases the quantity from 800 to 820 million euros.

Who buys Foreign Exchange?

1. Importers
2. Exporters
3. Investors of Foreign Assets
4. Central Banks
5. Tourists

6. Speculators
- Buy or sell foreign exchange in hopes of profiting later by trading the currency at a more
favorable exchange rate.
- By taking risks, they aim to profit from market fluctuations – they try to buy low and sell
high.

7. Arbitrageurs
- Money dealers who take advantage of tiny differences in exchange rates between
markets
- For example, if one euro trades for $1.30 in New York but for $1.31 in Paris, an arbitrageur
could buy euros in New York and at the same time sell euros in Paris.
- Arbitrageurs take less risk than speculators because they simultaneously buy currency in
one market and sell it in another.

8. People Seeking a Safe Haven for their Money

- Those people in countries suffering from economic and political turmoil may buy more
stable currencies as hedge against the depreciation and instability of their own currency.

Exchange Rate Systems

1. Flexible Exchange Rate/Floating Exchange Rate
- The exchange rate adjusts continually to the many forces
that affect the foreign exchange market (e.g. the demand
and the supply)
- Government officials usually have an indirect role in foreign
exchange markets
 - Since 1970, the Philippines have been maintaining a flexible exchange rate system.

2. Fixed Exchange Rate/Pegged Exchange Rate

- Exchange rate that is fixed, set, and maintained by the
central banks’ ongoing purchases and sales of currencies
- It requires the central bank/government intervention to
establish and maintain this exchange rate system.