EBC 101 / ECO 1: Introductory Economics

MODULE I: OVERVIEW OF AN ECONOMICS SYSTEM

SCOPE OF THE MODULE

This module consists of three lessons, namely:
Lesson 1 Nature of Economics
Lesson 2 Economic Systems and Their Problems
Lesson 3 Circular Flow Model of Production and Income

OVERVIEW OF THE MODULE

This module derives the functional definition of Economics. It further identifies
common economic goals that a nation, whether developing, faces in whatever type of
economic system it has adopted to solve the basic economic problems of that nation. In
the process of developing, an economic system evolves around the interplay of the
households, the firms, the government, and the external market.

LEARNING OUTCOMES OF THE MODULE

After completion of this module, you should be able to:
1. delineate Economics as a social science;
2. distinguish Macroeconomics from Microeconomics;
3. prioritize the economic goals that should be tackled by the country in its
economic recovery venture to be added;
4. differentiate how the different economic systems solve the three basic
economic problems of a nation; and
5. evaluate the capacity of the Philippine economy to sustain the needs of its
growing population upon update of data.

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 Thought Supplement:
Scarcity
Read on the nature of scarcity as the focal point in the study of economics.
Follow the link to see how western countries deal with water scarcity.
https://courses.lumenlearning.com/baycollege-introbusiness/chapter/what-is-
economics-and-why-is-it-important/
Opportunity Cost
Watch this video on how we calculate the value of forgone choices
https://www.youtube.com/watch?v=whZORVxPaLE
Summary on the Basic Concepts
Watch this video as we synthesize Module 1
https://www.youtube.com/watch?v=2izx5W1FAEU
Circular Flow of Goods and Services
How the leakages balance the inflows? This video presents the economic
activities of the sectors in a market economic system.
https://www.youtube.com/watch?v=_PKH2wtDT3E
Economic System
The video presents 19th century economic thoughts that compares the three
common economic systems: Communism, Socialism and Capitalism.
https://www.youtube.com/watch?v=FrtDZ-LOXFw

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 EBC 101 / ECO 1: Introductory Economics
MODULE I, LESSON 1: NATURE OF ECONOMICS

LESSON OUTCOMES:
After completing this lesson, you should be able to:
1. characterize the word "Economics";
2. understand the concept of scarcity and relate this concept to reality; and
3. appreciate the need for studying Economics.

SCARCITY (RESOURCES VS WANTS)

Economics is all about scarcity. Just what is scarcity? Let us take the case of Lyn
Yan, a first year college student. Every month she receives PhP1,000.00 allowance
from her parents. For this period she believes she must spend the following amounts:
Food PhP 600
Housing 200
Clothing 200
Laundry 100
Recreation 100
Miscellaneous 50
Lyn is confronted with an economic problem. She thinks she must spend PhP
1,2500 but she only has PhP 1,000.00. Her resources are not enough to satisfy her
needs.
The problem confronting Lyn is not at all unusual. Everyone around us, rich or poor,
is faced with the same economic problem - resources are scarce relative to unlimited
wants. What does this imply? Man cannot have everything. Not all of man's needs can
be satisfied. There is shortage of goods. This is the concept of scarcity. This has given
birth to the study of Economics.

OPPORTUNITY COST (SCARCITY AND TRADE-OFF)

Scarcity is one fundamental problem of every society. With scarce resources and
unlimited human wants and needs, there could be limitations along the way. Opportunity
cost is the forgone alternative of a product or service. Establishing one’s priorities is
important in the process of decision-making so one chooses the alternative that will give
the higher level of satisfaction.
Everyday endeavors entail opportunity cost! The tardiness of attending classes will
cost one to miss lectures. Stephanie Joy decided to watch Breaking Dawn with friends

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so she did not finish her assignment on time. Jonathan Troy accepted the chance of
going abroad so he lost his chance for a college diploma. Residents of San Mateo don’t
want to be relocated for the government’s proposed water reservoir, so they lost the
benefits of having potable water, possible supply of electricity and farm irrigation. All
these are situations where trade-off exists. One has to critically analyze choices that will
have the least sacrifice and the greatest benefit.

ECONOMICS DEFINED.

Scarcity is a fact of life. No one has everything. There is a shortage of goods to

satisfy human wants.
The concept of scarcity is therefore expressed as:

Economic Resources < Human

Wants
With this in mind, let us now define Economics. According to Gerardo Sicat, a well-
known Filipino economist, Economics is a scientifically study which deals with how
individuals and society generally make choices.
What are these choices? We know that individuals and groups in society have
innumerable wants. These wants are satisfied by goods and services produced in the
economy. Resources are used to produce these goods. But resources are not freely
available. They are scarce. They also have alternative uses. Thus there is a dimension
of choice - how will society allocate its scarce resources to produce goods and services
in order to satisfy human wants?

ECONOMIC RESOURCES (FACTORS OF PRODUCTION)

Goods and services are the things man seeks to satisfy his wants. Goods are
concrete things. They are tangible like rice, fish, roads, buildings. Services on the other
hand, are intangible. Teaching rendered by teachers to students is an intangible
service.
Society uses its economic resources to produce the goods and services man needs.
What are economic resources? Unlike Lyn Yan, a society's economic resources are the
amounts of money it has to spend. Its resources are the amounts of labor, land, capital
goods and entrepreneurial ability, which it can employ to produce the things people
want. There resources are also known as the factors of production. Bernard Villegas
described each of the factors as follows:
Land includes all natural resources, including land, everything beneath and above
it, minerals, water, air, trees, poultry, livestock, and all other forms of these raw
materials used in production.
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 Labor refers to all human beings who extract raw materials process these raw
materials info finished consumption or investment goods, transport and sell raw
materials or finished products.
Capital refers to man-made goods used to produce other goods. They include
materials such as tools, machinery and equipment.
Entrepreneur is a person who puts together or organizes the other factors of
production to generate goods and services, which can satisfy the man needs.
If more labor resources (than capital) are employed, the producing unit is said to be
labor-intensive. On the other hand, if the producing unit opts to employ more capital
goods (than labor) it is said to be operating on a capital-intensive technology.
The amount of resources a society has determines its productive capacity. At a
particular time, there are just so much economic resources available. Since the
economy has a fixed amount or resources at a given time, how can it satisfy as many
wants as possible? The answer, by being efficient! An economy is efficient it there is
both full production and full employment. Full employment is employing all resources to
produce goods and services. Full production means using the best available methods to
produce the goods.
Let us take this example. A Filipino economy employed some of its labor resources
to produce motorcycles. Each motorcycle worker toiled by himself in his own backyard
with only a hammer and a hacksaw. This example shows an inefficient economy. It did
not employ its resources efficiently; neither did it use the best methods of producing
motorcycles.

PRODUCTION - POSSIBILITIES FRONTIER

We have learned quite a bit about scarcity and economics. To recall, we know that
there is not one economy that can satisfy all of man's needs. Why is this so? Why can't
we product all the things that we need? Because resources are limited in supply! If the
available land is used for rice production, there is no more space for sugar production.
Let us examine the table below to throw more light on scarcity and the problem it
creates.

Combinations
Goods A B C D E F
Food 0 1 2 3 4 5
Clothing 20 18 15 11 6 0
Production Possibilities Table
This table shows the different combinations of two goods it is possible to produce

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when there are both full employment and full production in a hypothetical economy
whose resources remain fixed.
To keep our illustration simple, let us assume that the economy is capable of
producing food and clothing only.
This table is called a production possibilities table because it shows the different
combinations of food and clothing it is possible to produce. We can see that there are
six different combinations. One of these is combination D. If the economy produces this
combination, it produces 3 units of food and 11 units of clothing. Should it decide to
produce 1 unit of food it could produce 18 units of clothing. The economy finds if
impossible to produce 2 units of food and 20 units of clothing. Neither can if produce 6
units of food and 6 units of clothing. It is impossible to produce these combinations
because the resources are fixed and definitely are not enough. What does the table
reveal to us? One of the things we notice if this production possibilities table is that
when the economy increases its production of food, it must decrease its production of
clothing. Were it to decrease its production of food it would be able to increase its
production of clothing.
Why must the economy decrease its production of one good to be able to increase
its production of the other good? To produce more food the economy must use more of
its fixed quantity of resources for food production. And if it uses more resources to
produce food there are fewer resources left to produce clothing.
Applying this to reality, the only way we can produce more of anything is to produce
less of something else.
The production possibilities table does not tell us which combination the economy
must produce. But it does tell us that the economy must make a choice. Together with
this, the table also tells us the cost of producing the goods. Cost, in economics means
the sacrifice that must be made (or what must be done without) in order to produce a
good. The amount of clothing that must be sacrificed in order to produce additional food
is called opportunity cost of producing clothing. Referring to the production possibilities
table, to increase the production of food from 2 to 3 we have to decrease the production
of clothing by 4 (from 15 to 11). The opportunity cost of the third unit of food is 4 units of
clothing. Should the economy wish to increase its production of food from 3 to 4, it
would have to do without 5 units of clothing. Five units is the opportunity cost of
producing this additional food.
We have seen and learned that regardless of whether we are talking about food or
clothing, the opportunity cost increases as the production of the good increases.
Suppose we present the production possibilities table on a graph and see how it
looks like. With the use of the same data the production possibilities curve would look
like this:

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 25

CLOTHING 20

15

10

0
1 2 3 4 5 6
FOOD

The curve is downward, sloping, and concave. The downward sloping curve reflects
the opportunity cost of producing a good. To recall again, to get more of one kind of
good (food) we must give up or sacrifice some of the other (clothing), and vice versa.
Why is the curve concave? Why is it not a straight line? Note that as we move down
the curve, we get fewer units of clothing for the same unit of food. If we give up one unit
of food, say from 5 units to 4 units, clothing would increase by 6 units. Further increase
by 1 unit of food (from 4 to 3) will yield a lesser additional quantity of clothing by 5 units
from 6 to 11). Why is this so? Why does the sacrifice of the same quantity of food yield
an increasingly smaller additional quantity of clothing? The answer is this: While we
know that the economic resources used in production have alternative uses, these
resources are not completely adaptable. Let us assume in our example that there are
100 farmers and 50 dressmakers employed. If we want to produce more clothing,
farmers have to be taken out and sent to work as dressmakers or vice versa. Common
sense will tell us that a farmer is not as productive in dressmaking as a dressmaker.
Neither is a dressmaker as productive in farming as a farmer.
Secondly, resources in production are fixed. As the number of workers in food
production increases, other resources (land, tractors) will no longer be sufficient for
everyone's use. Overcrowding will result. Others will have to wait to take turns in using
the resources. Efficiency is affected; hence, as more and more dressmakers shift to
farming, the increase in food production tends to decline. The contribution of the last
new farmer decreases. Such phenomenon is said to exhibit the Law of Diminishing
Returns. This is the reason behind the concavity of the curve.
The Law of Diminishing Returns states that as more of the same input (in our case,
labor) is employed in the production of a particular good (in our example, food), the
corresponding increase in total output tends to become smaller and smaller, if the
amounts of the other inputs (e.g., equipments and materials) required in the production
EBC 101 / Eco 1 – Introductory Economics
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process are kept constant.
The production possibilities curve also reveals to us the area whose combination are
attainable with the fixed amount of resources. Let us take a look again at the curve
below.

25

20
D
CLOTHING

15
A
10 C B
5

0
1 2 3 4 5 6
FOOD

Combinations of food and clothing from the curve down to the area below it are
attainable. Above the curve, production is no longer possible.
Let us take points A and B. These points are exactly along the curve, which means
they are definitely attainable. Resources at these points have been fully utilized.
A or B is a wise choice. Point C's combination is also attainable, but it does not use
up all of the resources. Point C is not a wise choice. The area above the curve where
point D is located is simply not attainable. Why? This is because resources are
inadequate. The resources available can only produce that much up to the curve where
points A and B are located. Let us now pause and take a look at the Philippine situation,
into the nation's natural and human economic resources.

THE PHILIPPINE SITUATION

Its Land Resources . The Philippine has a total land area of approximately 30.00
million hectares. As of 2006, of this, 14.21 million hectares (48%) of land are alienable
and disposable. The Bureau of Agricultural Economics placed total crop area under
cultivation at 12.2 million hectares. Only 2.5 million hectares are left undeveloped and
uncultivated.
The remaining land, constituting about 15.79 million hectares, are forest lands.
These are the country's source of timber and other wood products. However, present
practices like kaingin-making, forest burning and illegal harvesting of new timber plant
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products persist.
As of the present, we only have approximately 1.2 million hectares remaining of
virgin forests.
Drastic measures are now being undertaken to slow down the rate of forest cover
loss. Imposition of log ban and reforestation efforts is being accelerated.
Its Marine Resource. According to the Bureau of Fisheries and Marine Resources
BFAR (2009), the harvested potential of our marine resources is 2.2 metric tons per
year over a 2,200 sq. km. total territorial water area. However, as early as 1984,
Philippine Fisheries production has reached 2.1 metric tons already.
Present practices like illegal and destructive fishing methods (explosives),
destruction of mangroves and coral reefs, as well as over-exploitation and pollution are
threatening our coastal and aquatic resources.
It is obvious at this point that our natural resources are becoming scarce through
time because of the country's population growth, not mentioning the destruction created
by man.
The basic needs of its populace dictate the demand for these resources. Now, let us
have a short profile of the Filipino population.
Its Labor Resource. Report from the National Statistics Office on the Labor Force
of our country may be found at http://www.census.gov.ph/statistics/survey/labor-
force/lfs-index.

ECONOMIC GOALS

We have learned that the capacity of a nation to sustain itself depends on the quality
and quantity of its economic resources. These resources must be used to their
maximum sustainable potential (in producing goods and services) to satisfy the
common needs of its populace. But what does a nation's populace need in the process
of development? Or what are the economic goals of a nation?
Development economists tend to agree that in the different stages of a country's
development (whether categorized as developing, newly developed, or undeveloped),
there are common goals to be achieved:
1. increase in per capita income;
2. equitable distribution of income and wealth among individuals and regions;
3. balanced foreign exchange; and
4. full employment and/or development of its resources.
The Ramos Administration gave priority to the alleviation of poverty by generating
more productive employment, enforcement of the Comprehensive Agrarian Reform
Program and privatization of government acquired assets, among others.
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 The goal of uplifting the poor emanates from the recognition that human resources
are the most important asset of any society.
The promotion of equity and social justice is another goal that the government is
determined to pursue. Political and economic arrangements have been made to ensure
and provide incentives on the basis of accessibility to power to one, which gives
importance to efficiency and equity considerations. The passage of the Local
Government Code is expected to realize this goal. The code seeks to provide better
investment opportunities and employment privileges among the people, especially in the
rural areas.

ECONOMIC METHODOLOGY (POSITIVE AND NORMATIVE ECONOMICS)

In exploring the basic principles of Economics, students must learn to distinguish two
types of statements: statements about what is and statements about what ought to be.
Critical thinkers must be able to contrast statements and how these bring about
meaning to an idea. Positive Economics shows causality of two variables. It is
consistent to what we observed in the world. It is a statement emphasizing a fact and
stated objectively. Normative Economics on the other hand presents matters of opinion.
It dwells on making judgments and inferences on an idea or thought. It is often
subjective and debatable.
For example:
1. the subject matter on poverty
Positive Economics, PE: National statistics reported that 25% of the populace
is below poverty threshold.
Normative Economics, NE: All Filipinos are poor.
2. the subject matter on price and inflation
Positive Economics, PE: The weekend sale among malls (10-30% dropped
on prices) doubled business revenues on weekends.
Normative Economics, NE: Government must reinforce punishment on price
padding for basic commodities.

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EBC 101 / ECO 1, Module 1, Lesson 1
SELF-PROGRESS CHECK TEST

Test I. Multiple Choice

_____ 1. Economics is the study of:
a. the nature and causes of the wealth of nations
b. the nature of production and the distribution of wealth
c. the allocation of scarce resources among competing ends
d. all of the above
_____ 2. Scarcity means that:
a. at the current market price is a shortage of the good
b. a particular good is extremely difficult to produce
c. our desire for a good exceeds the amount that is freely available
d. we are unable to find a particular good in any of the stores we visit on
a shopping trip
_____ 3. Which of the following would be considered a free good?
a. a freeway
b. free parking
c. sunshine
d. a public school education supported by taxes
_____ 4. Which of the following scarce resources is defined as a "man-made
means of production?"
a. land
b. labor
c. capital
d. entrepreneurship
_____ 5. Which of the following is an economic statement of opportunity cost?
a. in any exchange situation, what one person gains someone else must
lose
b. not all individuals will make the most of life's opportunities - some will
fail to achieve their goals
c. executives do not always recognize opportunities for profit as quickly
as they should
d. since goods are scarce, in order to get something you must give up
something in return
_____ 6. Since resources are not free, if we want to acquire more of one good or
EBC 101 / Eco 1 – Introductory Economics
14
 service, we must give to another in order to get it. The term that
economics uses to express this concept is
a. scarcity
b. opportunity cost
c. comparative advantage
d. the law of diminishing returns
_____ 7. Which of the following factors would not result in an outward shift of the
production possibilities curve over time?
a. improved technology
b. putting unemployed resources of work
c. an increase in the size of the available labor force due to an increase
in population
d. the discovery of a new source of vitality needed raw materials
_____ 8. The concept of scarcity suggests that:
a. Economic Resources = Human wants and needs
b. Economic Resources > Human wants and needs
c. Economic Resources < Human wants and needs
_____ 9. Which of the following factors would result in an inward shift of the
production possibilities curve over time?
a. improved technology
b. the destruction of farm lands in Central Luzon due to Mt. Pinatubo's
eruption
c. an increase in population
_____ 10. An economic resource that puts together and organizes the other factors
of production to generate goods and services
a. land
b. labor
c. entrepreneur
d. capital

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Test II. Matching Type
Column A Column B
_____ 1. central problem of (a) process of choosing an economy's product
any economic mix
society
(b) employing all resources to produce goods
_____ 2. allocation of and services
resources
(c) amount of one commodity given up to obtain
_____ 3. attainable another
combination of
(d) problem that forces the economy to produce
goods assuming full
inside production possibilities boundary
production and full
employment (e) if more of the same input is used, the
corresponding increase in output tends to
_____ 4. unemployment of
become smaller and smaller assuming all the
resources
other factors of production remain constant
_____ 5. opportunity cost
(f) scarcity of resources in the face of relatively
_____ 6. full production unlimited wants
_____ 7. full employment (g) production possibilities boundary
_____ 8. Law of diminishing (h) using the best available methods to produce
returns the goods
_____ 9. Positive Economics (i) statement of a fact and supported by
statistics
_____ 10. Normative
Economics (j) statement of what ought to be and often
debatable.

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 EBC 101 / ECO 1: Introductory Economics
MODULE I, LESSON 2:
ECONOMIC SYSTEMS AND THEIR BASIC PROBLEMS

LESSON OUTCOMES:
After completing this lesson, you should be able to:
1. appraise the fundamental economic problems faced by any society;
2. describe the 3 forms of economic systems;
3. illustrate how economic systems work to solve the economic problems; and
4. compare and contrast the economic system adopted by the Philippines.

INTRODUCTION

In the previous lesson, we have learned that a society's economic resources limit its
productive capacity to fulfill the needs of man. Considering man's innumerable wants
and needs an economy has to choose from among a multiplicity of goods to produce or
consume. Hence there is a need to make a choice, the best choice if possible, because
of the opportunity cost that is incurred in every decision.
Every society is faced with 3 fundamental economic problems. These are the choice
it must make:
1. What and how much to produce.
2. How to produce.
3. For whom to produce.

BASIC ECONOMIC PROBLEMS

The first major problem faced by an economic system is choosing what goods and
services are to be produced and in what quantities. Why should every society bother
itself with his two-fold problem? If people need sufficient food, proper clothing,
comfortable shelter, good quality of education, peace and order, etc. by all means let's
produce these things! But wait! Do we have all the necessary land, labor, and capital
resources to produce all of these needs for the 92 million (and more!) Filipinos? No,
because these resources are scarce. Once a decision is made about producing a
particular product say X, a society is simultaneously giving up the opportunity of
producing and, therefore, enjoying some other products like, Y, Z, U, or W.
Suppose the government decides to boost its educational program as a top priority.
It increases its budgetary allocation for building new schools, renovating existing
government facilities and equipment, expansion of scholarship for the "poor but

17
deserving", promotion of science and mathematics, upgrading the wage structure of the
public school system. In choosing this program, the government gives up the other
opportunity of possibly buying new defense equipment for the Armed Forces and for the
government hospitals. Hence, this increase in the budget for education can cause a
decrease in the budget for the other expenditure items of the government's budget. If on
the other hand, the government's thrust is to eliminate the insurgency problem, then
spending becomes high in buying new and high-powered weapons and gunships.
Hence, the millions of pesos spent on these imported weapons could have built
thousands of housing units, hundreds of irrigation dikes/dams, and feeder roads needed
for rural industrialization.
The second major problem faces by every nation is choosing how to produce a
certain commodity or service because there are technically many ways in which goods
can be produced. Dirty clothes can be washed by hands or by machine; a rice field can
be ploughed with a carabao or with a tractor; road construction can utilize machinery
and equipment in place in labor or vice versa; vegetables can be produced either by
having a small plot of land but with plenty of fertilizers and pesticides or by planting a
larger land area but with little input of fertilizers and insecticides.
In producing the same kind of good or service, there are a number of possible
combinations of resources out of which the producer may choose. Each particular
combination represents a production mix of resources, or a method of production or a
technology. When one chooses a production method that uses more labor inputs to
complement or to substitute for capital inputs (as we have discussed in Lesson 1), he is
said to be adapting a more labor-intensive technology. On the other hand, if one adopts
a production mix by using more capital inputs to complement or to substitute for labor
inputs, he is said to be using a more capital-intensive technology.
The choice of the technology to adopt would depend basically on the producer's
objectives and physical constraints. If he wants to solve unemployment and there is a
big labor force waiting for jobs he might prefer labor-intensive technology. If he wants
costly but high-quality hollow blocks he might prefer a capital-intensive technology to
ensure standardized units.
Adopting a technology that would use more scarce resources in higher proportions
increases the trade off or opportunity cost. The poorer the decision on the choice of
technology, the greater the opportunity cost incurred. This is why the producer needs to
gather the necessary information, which can help evaluate the merits of possible
alternatives before making a decision on how to produce.
The third equally important problem to be tackled by an economic system is knowing
for whom shall society produce? Shall society produce goods and services for the poor
or the rich families? Shall it favor the agricultural workers of the industrial workers? Shall
it give preference to this region over that region? Shall it discriminate against
landowners in favor of tenants, capitalists, in favor of workers?

18
 If more goods are produced for consumers, less food will be produced for investors.
If more of the budget of the government is allocated to benefit the armed forces, less
will be allocated to public teachers. Why? Because of the scarcity of resources?
It is also important to understand that economic system adopted by an economy
dictates the affairs of the various sectors of society. One additional question essential to
society, “How will the system adapt to changes?” With the continuing innovations in
production, nowadays, systems are challenged. Interdependence among countries
arises due to scarcity of resources. Often economic unions initiated to boost relationship
and optimization in the use of available resources.

BASIC ECONOMIC SYSTEMS

Because of scarcity every society must make a choice what to produce, how much
to produce, and for whom to produce. However, an even more fundamental choice that
must be made is that of who will make these decisions.
The decision on these choices is determined by the form of economic system that a
society adopts. There are 3 types of economic systems that may be adopted.
1. Tradition
2. Command
3. Market
Tradition. This is a type of economy whose economic choices are decided by the
past. A product is produced this way because it has always been produced this way. It
is tradition that determines the current level of output for commodity or service
produced.
Command. Under this type of system, an Economic-Commander-in-Chief or a
group of men determine the goods and services to be produced. The choices or the
wishes of the economic-commander-in-chief are the commands of the producers. What,
how much, how and for whom to produce are planned and dictated from above to those
involved in the production below.
Market. This system is coordinated through an interlocking network of markets and
prices. The suppliers of a particular product bring their supplies to market, where they
encounter the potential customers for the product.
The more consumers value a good or service, the higher the price that they are
willing to pay - which producers use as a basis for production and selling decision. If the
price is too high, consumers may opt not to buy. A bargaining process between the
buyer and the seller takes place which would result in a fruitful compromise.
Thus, in a market economy, the price of a commodity determines what, how much,
how and for whom goods are produced.

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 Any society can adopt either of the three. In reality, however, no economy adopts
either one or the other. It is usually a combination of these three. In the case of the
Philippines, tradition has a lot to do with the methods of say, rice production; the market
system has a lot to do with the pricing schemes of a number of commodities and the
government does intervene in a number of economic activities.

ROLE OF IMPORTANT ECONOMIC SECTORS

In any economy, decision makers are vital to address how wants and needs will be
satisfied. These institutionalized sectors vary in their roles and economic participations,
and these are:
a. Households. The owners of the factors of production and they are the
consumers of the final goods and services. The source of manpower for labor
force is basically the main function of this sector.
b. Business Firms. This is where production of intermediate and final goods
takes place. Production mode can be classified into proprietorship,
partnership, corporation, multi-national corporation, transnational corporation
and cooperative.
c. Financial Institutions constitute the banking and non-banking institutions.
They served as the repository of financial capital of an economy. They handle
saving and investment activities.
d. Government/Public Sector is composed of local and national government
agencies responsible for providing public goods and services. It also
facilitates the transfer and collection of public funds.
e. External Sector refers to the rest of the world. Any foreign country with direct
economic relationship with another country. Relationships are primarily of
export-import activities and foreign investment.

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EBC 101 / ECO 1, Module 1, Lesson 2
SELF-PROGRESS CHECK TEST

Multiple Choice.
_____ 1. The particular form of social arrangements through which the three
fundamental questions ("what," "how," and "for whom") are answered is
called:
a. capitalism
b. socialism
c. the zero sum society
d. an economic system
_____ 2. The three principal types of economic systems are:
a. capitalist, socialist and mixed
b. traditional, command and market
c. traditional, capitalist and socialist
d. market, socialist and mixed
_____ 3. A traditional society is characterized by:
a. acute society
b. subsistence of food gathering and primitive agriculture
c. very low levels of specialization and trade
d. all of the above
_____ 4. In command societies the three basic question ("what," "how" and "for
whom") are all answered:
a. through a system of markets
b. by tradition and one's social standing
c. by central authority
d. by the laws of supply and demand
_____ 5. In a market society, the three fundamental questions ("what," "how," and
"for whom") are answered by:
a. central authority
b. traditional standing within the social hierarchy
c. impersonal forces guiding the decisions of consumers and producers
d. a system of political checks and balances that leads to a system of
general equilibrium
_____ 6. A major difficulty of barter exchange is that:
a. as the number of traded goods increases, calculating the "exchange
ratios" becomes extremely complicated and time consuming

21
 b. it is difficult for individuals to decide what they really want when so
many choices are available
c. the central authorities usually make it illegal to make such an
exchange
d. even though barter exchange is efficient, transporting goods becomes
difficult at times.
_____ 7. An economic sector that facilitates the transfer of public funds and
collection of public funds through taxes.
a. Households
b. Financial Institutions
c. Public/Government Sector
d. External Sector
_____ 8. This sector refers to the rest of the world, where foreign activities such
imports and exports take place.
a. Households
b. Financial Institutions
c. Public/Government Sector
d. External Sector
_____ 9. They are said to be the basic economic unit where resources are owned.
The vital source of manpower for labor force and entrepreneurs for
managing production.
a. Households
b. Financial Institutions
c. Public/Government Sector
d. External Sector
_____ 10. It functions as the repository of financial capital for savings and
investment. It comprises both the banking and non-banking institutions
a. Households
b. Financial Institutions
c. Public/Government Sector
d. External Sector

22
 EBC 101 / ECO 1: Introductory Economics
MODULE I, LESSON 3:
CIRCULAR FLOW OF PRODUCTION AND INCOME

LESSON OUTCOMES:
After completing this lesson, you should be able to:
1. characterize the sectors operating within an economy;
2. explain the effects of leakages in the economy; and
3. discuss how the economy’s stakeholders operate to balance its activities.

INTRODUCTION

Earlier we have seen the importance of an economic system in the allocation of

limited resources to satisfy human wants. An economic system is made of various
interdependent elements each performing a role in the economic process.
Production or economic activity (transformation of resources into goods and
services) and the process of exchange make up the economic process. In this lesson,
we will show the economic process and its effects on the economy.

CIRCULAR FLOW OF PRODUCTION

To begin with, let us imagine a very simple economy.

Economic resources (land, labor, capital)

E

Households (Resource owners) Firms (Producers)

P
Output of goods and services
Figure 1: Circular Flow of Production Process

23
 The households are the resource owners (landowners, laborers/employees,
capitalists). When they sell out their resources (land, labor, capital) to the producing
firm, the latter is said to be employing there resources as its factors of production. This
process of purchasing or using the economic resources into the production process is
called employment (E). With these employed resources, the firm can now produce
actual goods and service demanded by the growing nation. This process of
transformation of economic resources into actual goods and services is called
production (P). Hence, in the production flow one can view the product market.

CIRCULAR FLOW OF INCOME

What, in turn, do the households get out of selling out their resources to the firm?
When the firm employs the different production factors he pays back the resource
owners in the form of income (See Figure 2). The income incurred from the use of factor
labor is wage/salary. The income from the use of capital is interest. Income (Y),
therefore, is the payment or reward for the use of a resource producing something. With
income earned, the households now have funds to buy the goods that were produced
by the firms and that would satisfy his family's needs at the maximum level. The actual
purchase of final goods and services is the process called consumption (C).
Money Income
Y

Households (Resource owners) Firms (Producers)

C
Money Expenditures

Figure 2: Circular Flow of Financial Transactions

Funds that flow from households to the producing units represent money
expenditures (C) by the households on goods and services bought, as well as revenues
or receipts from sales by the firm. Funds that flow from the firms to the households
represent money income (Y) paid to resource owners, and also as money expenditures
(or cost) incurred by the firm in the production process. Hence, in the income flow, one
can view the money market.

24
 Y

Households (Resource owners) Firms (Producers)

Figure 3: Circular Flow of Production and Income

Figure 3 identifies two exchange transactions that happen between households and
firms. The first exchange transaction illustrated the product market, i.e., an exchange of
resources and output through the employment-production flow. The second exchange
transaction shows the money market, i.e., as exchange of money incomes and money
expenditures through the income consumption flow. Hence, money flows in a circular
manner from households to firms and back again, creating income as it circulates. As a
whole, the circular flow establishes the relationship between output, income and
spending. That is:
Output = Income = Spending
The above circular flow model summarizes Macroeconomics, the branch of
economics concerned with the process of resource allocation by individual decision
units (households and firms) or markets which are coordinated by the price system.
Hence, the economic behavior of both the households (demands) and the firms (supply)
among various market structures shall be discussed in Modules Two and Three.

INFLOW AND OUTFLOWS IN THE CIRCULAR FLOW MODEL

The assumptions we made earlier where all the incomes earned by the households
are spent on goods and services are, in reality not true. Households usually do not
spend all of their incomes on goods and services. Why? For one, part of it is saved for
future transactions. Let us suppose a close friend of yours will celebrate her birthday
next month. You plan to give her a simple gift. But because your allowance is limited,
you decide to set aside at least three pesos (PhP 3.00 a day) so that by the end of the

25
month, you have ninety pesos (PhP 90.00). The money set aside is your savings.
Savings, therefore, is income not spent. What happens to your capacity to buy goods?
Spending is decreased!
Money saved is leaked out (not spent back) from the whole economic system.
Hence savings (S) become an outflow (Figure 4).

Y
Inflow

E I

Households Firms Financial Institutions

P S

Outflow
C

Figure 4: Savings = Investments

However, there are institutions that can attract these saved funds into very useful
spending. Through the different financial institutions like banks, these saved funds can
be a source of investible funds needed by the business firms in their expansion
program. Once the firm borrows funds from the banks and purchases its new capital
good requirement, the firm is said to be investing (I). This is an injection of money into
the system. Investment becomes an inflow of the circular flow.
Secondly, households pay the government in the form of taxes. Taxes (Tx) lessen
one's capacity to spend. They are leakages or withdrawals from the circular flow (Figure
5).
However, tax collections in turn are used by the government when it spends for
infrastructure projects (e.g., roads, piers, airports) or for public services (e.g., health,
education, medical). These are inflow of public funds into the system (Figure 5).
Lastly, households spend a part of the income they earn on imported goods -
Cadbury chocolates, apples, grapes. These products come from other countries and
sold here. So that when we buy imported goods there is an outflow of pesos from the
economic system. Importation (M) is another form of leakage in the circular flow (Figure
6).

26
 Y
Inflow

E G

Households Firms Government

P Tx

Outflow
C

Figure 5: Flow of Public Funds

Y
Inflow

E X

Households Firms Foreign Trade Market

P M

Outflow
C

Figure 6: Flow of Dollars

Let us now pause for a while and review the circular flow model, and how the
economic system operates. Together with the households and firms, the different
banks, the government, and the international trade market participate in moving the
economy. Savings (S), Taxes (Tx), and Imports (M) do not remain in circular flow. They
are like leakages and constitute outflows or withdrawals from the circular flow. On the
other hand, investment (I), government expenditures (G), and proceeds from exports
(X) to the rest of the world are inflows or injections of income originating from outside of
the circular flow.

27
 Their effect on the circular flow and on national income depends upon how much
outflows are offset by the inflows. Outflows, being part of income, are largely
determined by income. If income increases, outflows tend to increase, or vice versa.
Inflows, on the other hand, are determined by policies - monetary, fiscal and trade
policies.
The imbalance that often times exists between outflows and inflows changes the
circular flow, thus affecting the whole economy. When outflows exceed inflows, funds
are taken out of the circular flow. The consequences are that proportion (P),
employment (E), income (Y), and consumption (C) fall. Conversely, when more funds
are introduced into the circular flow because inflows are greater than outflows, there is a
rise in production, employment, income and expenditures.
The above discussion summarizes macroeconomics, the behavior of the different
sectors - households, business sector, government sector and the international sector.
These shall be discussed further in Modules four and five.

28
EBC 101 / ECO 1, Module 1, Lesson 3
SELF-PROGRESS CHECK TEST

Multiple Choice.
Where would each item (a through o) below be shown in the following flow categories?
1. Circular Flow of Production Process
2. Circular Flow of Financial Transactions
3. S-I Flow
4. Flow of Public Funds
5. Flow of Dollars
_____ a. overtime wages paid by Delta Motors
_____ b. payments for iron ore from Lepanto Mines by Grill Builders, Inc.
_____ c. interest paid on publicly held DBP Countryside Bonds
_____ d. money used by housewife Mrs. Quezon for weekly deposit in the Aurora
Rural Bank
_____ e. purchases of kilowatts by Meralco from National Power Corporation
_____ f. sales tax collected at the Merced Drug Store
_____ g. tuition fee payment to a college by the father of a student
_____ h. government welfare check under the Veterans' Aid-to-Dependent-Children
program
_____ i. purchase of 2 Japanese agricultural tractors by Polilan Farmer's
Cooperative
_____ j. hiring of 5 industrial sewers to finish 100 dozens of baby dresses by
Segari Garments Inc.
_____ k. applying for a loan at the Bank of America for expanding a poultry farm
_____ l. leasing 3 hectares of land to plant cassava by Republic Flour Mills
_____ m. buying a time deposit certificate from the BPI Agribank
_____ n. selling of desiccated coconut oil by Mang Pepe to Russia
_____ o. using a charcoal stove to cook arroz caldo to be sold at the plaza during
the town fiesta.

29
EBC 101 / ECO 1, Module I
ANSWER KEYS TO THE SELF-PROGRESS CHECK TESTS

Lesson 1
Test I
1. d 3. c 5. d 7. b 9. b
2. c 4. c 6. b 8. c 10. c
Test II
1. f 3. g 5. c 7. b 9. I
2. a 4. d 6. h 8. E 10. j

Lesson 2
1. d 3. d 5. c 7. c 9. a
2. b 4. c 6. a 8. d 10.b

Lesson 3
a. 2 d. 3 g. 2 j. 1 m. 3
b. 2 e. 4 h. 4 k. 3 n. 5
c. 4 f. 4 i. 5 l. 1 o. 1

30
 EBC 101 / ECO 1: Introductory Economics
Module Test I

Name: DLC: Score:

Test I. Multiple Choice.

_____ 1. Economic theories:
a. are abstractions and therefore of no application to real situations.
b. are generalizations based upon careful observation of facts.
c. are true for individual economic units but are never true for the
economy as a whole.
_____ 2. Macroeconomics is concerned with:
a. establishing an overall view of the operation of the economic system.
b. the concealing of detailed information about specific segments of the
economy.
c. a detailed examination of specific economic units which comprise the
economic system.
_____ 3. Macroeconomics approaches the study of economics from the point of
view of:
a. individual firms.
b. individual consumers.
c. government units.
d. the entire economy.
_____ 4. In economics, the problem is essentially deciding how to make use of:
a. limited resources to satisfy limited wants.
b. unlimited resources to satisfy limited wants.
c. limited resources to satisfy virtually unlimited wants.
_____ 5. When an economist says that material wants are insatiable,
a. the structure of consumer wants is highly unpredictable.
b. the structure of consumer demand varies from time to time and from
country to country.
c. these wants are virtually unlimited and therefore incapable of complete
satisfaction.
d. economic resources: land, labor, capital and entrepreneurial ability.
_____ 6. The fundamental problem of economics is:
a. to achieve a more equitable distribution of money income in order to
minimize poverty.

31
 b. the scarcity of productive resources relative to material wants.
c. the establishment of prices which accurately reflect the relative
scarcities of products and resources.
_____ 7. Economic theorists
a. make assumptions that simplify problems.
b. develop theoretical models that will yield testable hypothesis.
c. check hypotheses by appealing to facts.
d. refer to all of the above.
_____ 8. One of the major methods of problem solving used by economists is:
a. intuition
b. custom
c. holistic approach
d. the marginal approach
_____ 9. Economic goods are termed as "scarce goods" because they:
a. are not available in sufficient quantities to satisfy all wants for them.
b. are not produced in sufficient quantities to satisfy the effect of demand.
c. are of high quality
d. none of the above
_____ 10. "Distribution" in economics refers to:
a. retailing, wholesaling and transportation
b. what
c. how
d. for whom
_____ 11. Which of the following is true of basic economic problem of scarcity?
a. The problem is with us as long as resources are not available in
unlimited amounts.
b. The problem exists only in highly industrialized economies.
c. The problem will quite likely disappear as production increases.
d. The problem will be sure to disappear with the growth of technology.
_____ 12. The concept of economic efficiency is primarily concerned with:
a. the different institutions fostered by the various "isms".
b. the conservation of irreplaceable natural resources.
c. obtaining the maximum output from the available resources.
d. considerations of equity in the distribution of wealth.
_____ 13. Money is not considered to be an economic resource because:
a. money is not a free gift from nature.
b. the terms of trade can be determined in non-monetary terms.

32
 c. the idle money balances do not earn interest income.
d. money, as such, is not productive.
_____ 14. In economics, we are forced to make choices because resources are:
a. insatiable.
b. scarce wants are unlimited.
c. common property
_____ 15. An economy in which government bureaucrats make most of the
economic decisions regarding what to produce and how much to produce:
a. a subsistence economy
b. a market economy
c. a planned economy
d. none of the above
_____ 16. Which of the following statements best describes opportunity cost?
a. A bird in the hand is better than two in the bush.
b. Nothing ventured, nothing gained.
c. There is no such thing as a free lunch.
d. What goes up must come down
e. Do unto others as you would have them do unto you.
_____ 17. The money businesses pay for resources constitutes:
a. income to resources owners
b. the supply of resources
c. the product market
d. the resource market
e. part of the real flow
_____ 18. The distribution of income in a capitalist system is primarily determined by:
a. control over resources
b. control over products
c. the government
d. businesses
e. none of the above
_____ 19. The circular flow of income model shows
a. that consumers demand products and supply resources.
b. that producers supply products and demand resources.
c. that the two basic institutions of households (consumers and
businesses (producers) are each demanders and suppliers.
d. that the real flow and the money flow are in opposite.
e. all of the above

33
_____ 20. Capital products are
a. money
b. man-made products used to produce other products
c. products that consumers purchase and use more or less immediately
d. products that satisfy our wants directly
e. technology
_____ 21. An economic sector that facilitates the transfer of public funds and
collection of public funds through taxes in an economy is known as
a. Households
b. Financial Institutions
c. Public/Government Sector
d. External Sector
e. Business Firm
_____ 22. This sector refers to the rest of the world, where foreign activities such
imports and exports take place.
a. Households
b. Financial Institutions
c. Public/Government Sector
d. External Sector
e. Business Firm
_____ 23. They are said to be the basic economic unit where resources are owned
(___) are said to be the vital source of manpower for labor force and
entrepreneurs for managing production.
a. Households
b. Financial Institutions
c. Public/Government Sector
d. External Sector
e. Business Firm
_____ 24. It functions as the repository of financial capital for savings and
investment. It comprises both the banking and non-banking institutions.
a. Households
b. Financial Institutions
c. Public/Government Sector
d. External Sector
e. Business Firm
_____ 25. The entity where production takes place within the economy is known as
(___). It converts factor inputs to becoming intermediate goods and final
goods ready for general consumption.

34
 a. Households
b. Financial Institutions
c. Public/Government Sector
d. External Sector
e. Business Firm

Test II. Matching Type

Column A Column B
_____ 1. natural resources a. labor resources >
_____ 2. scarcity capital resources
_____ 3. labor intensive technology b. capital
_____ 4. quota system c. government revenues
_____ 5. traditional economy d. subsistence level of
production
_____ 6. price mechanism
e. market economy
_____ 7. taxes
f. supply and demand for
_____ 8. government spending
money
_____ 9. monetary policies
g. economic policies
_____ 10. outflows
h. unspent income
_____ 11. inflows
i. income-based
_____ 12. entrepreneur
j. skilled human resource
_____ 13. equitable distribution of income
k. public investment
_____ 14. savings
l. wants vs. resources
_____ 15. macroeconomics
m. command economy
n. national income theory
o. economic goal
p. land

Test II. Essay

1. What form of economic system is adopted by the Philippines? Why? To what
extent?
2. If you were the head of this country, what economic goals will you declare during
your entire term? If to prioritize, how would you read these objectives? Why?
3. With the annual increase in population of one million, evaluate the capacity of the
Philippine economy to sustain the needs of the populace.

35