Republic of the Philippines

Bulacan State University College of Business Administration

AY 2023-2024

Learning Module on
Applied Business Economics
 Table of Contents
LESSON 1 ....................................................................................................
1 - 22
RESOURCES UTILIZATION AND ECONOMICS Factors
of Production The Circular Flow Model The Concept of Opportunity
Cost Positive and Normative Economics Types of Economic System
LESSON 2 ..................................................................................................
23 - 69
THE BASIC ANALYSIS OF DEMAND AND SUPPLY Methods of
Demand Analysis Forces that cause the demand curve to change
Occasional or seasonal products Substitute and complementary
goods Expectations of future prices Methods of Supply Analysis
Change in Quantity Supplied vs. Change in Supply Optimization in the
use of factors of production Changes in Demand, Supply, and
Equilibrium

LESSON 3 ..................................................................................................
69 - 91

THE CONCEPT OF ELASTICITY

Elasticity of Demand Price elasticity of demand Interpretation of the

Elasticity Coefficient Income Elasticity of Demand Cross price
elasticity of demand Elasticity of Supply Extreme types of Supply
Elasticity

LESSON 4 ..................................................................................................
92 - 99

CONSUMER BEHAVIOR AND UTILITY MAXIMIZATION

Goods and Services

Consumer Goods
Essential or Necessity Good Vs. Luxury Goods
Economic and Free Good
Tastes and Preferences
Maslow’s Hierarchy of Needs
The Economics of Satisfaction
The Utility Theory
Marginal Utility
Total Utility
 Introduction

Applied Economics/Economics as an applied science-It is the

application of economics theories and models in real life. It consist of

learning how choices effect individual decision-making and how the

availability of factors aid decision workers craft sound judgment

The word economics came from the greek words,oikos which

meanshousehold andnomus which means management or oikonomus

/oikonomia which means household management.-It is the study of how we

make decisions in a world where resources are limited-It is thesocial

sciencethat studies the human behaviour of people in the societyon how

they make their choices

Importance of studying economics:

1.Economics analysis provides us with guidelines to wise action and

behavior

2.To prudently evaluate our choices before making a decision;

3.To understand why there is a need to save and invest;

4.To understand why government work hand-in-hand with the private sector.

Pre-Test

Questions:1.The central problem of economics is scarcity. What is your

understanding about limited resource but unlimited wants?
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2.Why do we need to study economics?

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LESSON 1:1RESOURCES UTILIZATION AND ECONOMICS

Topics : Introduction to Economics

Factors of Production

The Circular Flow Model

The Concept of Opportunity Cost

Positive and Normative Economics

Types of Economic System

Abstraction

Post Test
Activity Exercise

Duration : 9-hours (to include VMG orientation)

RESOURCES UTILIZATION AND ECONOMICS

PROBLEM OF
SCARCITY

ALLOCATION
ECONOMIC PROBLEM
RESOURCES

Economics Defined

Economics is defined in various ways. In fact, if we will ask you how you understand

the word, you will give us another definition which may be different in language but would

have the same meaning as the others. However, we can define economics as the efficient

allocation of the scarce means of production toward the satisfaction of human needs and

wants. You might be wondering what the definition is all about. As you may have noticed,

there are two important concepts in the definition of economics.

The scarce means of production refers to our economic resources like land, labor

and capital, which we use to produce all the goods and services that we need and want.

But why do we produce and ultimately buy these goods and services? Because they give

us satisfaction!

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 The problem however is that we do not have enough resources to produce all the

goods and services that we desire. This is because our resources are limited or scarce

while our wants are generally unlimited. Given this condition, we cannot produce

everything that we want since there is scarcity or limitedness of resources. This is where

economics comes in: we try to make the best of a lessthan-ideal situations. In other words,

we try to use our limited resources by efficiently allocating them so that we are able to

produce all the goods and services that will maximize our satisfaction.

In the succeeding discussions, we take a closer look at the concepts of resources,

scarcity, and satisfaction of human wants.

Origin of the word “economics”

The two Greek roots of the word economics are oikos – meaning household – and

nomus – meaning system of management. Oikonomia or oikonomus therefore means

the “management of household”.

With the growth of the Greek society until its development into city-states,

the word became known or was referred to as “state management”.

Consequently, the term, “management of household” now pertains to the microeconomic

branch of economics, while the phrase “state management” presently refers to the

macroeconomic branch of the economic (Fajardo 1977). Because of its far reaching

significance, in the early year economics covered other scholarly fields, such as religion,

philosophy, and political science.

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Scarcity: The Central Problem of Economics

Scarcity is the basic and central economic problem confronting every man and

society. It is the heart of the study of economics and the reason why you are studying it

now.

Authors have defined scarcity in different ways – some of which are complexly

stated while others are simplified exposition of the concept. One author in particular

defines scarcity as a commodity or service being in short supply, relative to its demand

(Kapur 1997) which implies a constant availability of a commodity or economic resource

relative to the demand of them. In

quantitative terms, scarcity is said to exist when at a zero price there is a unit of demand,

which exceeds the available supply (Kapur 1997).

Scarcity can also be looked in to as the limited availability of economic resources

relative to man’s or society’s unlimited demand for goods and services.

Since human wants and needs are unlimited and the available resources are finite,
scarcity naturally results leaving the society with the problem of resources allocation (See
Figure 1.1)

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Figure 1.1 Problem of Scarcity

Limited Resources Unlimited resources

Scarcity

The figure illustrates the interaction of limited resources available and the
unlimited wants of man and society. If limited resources fall short to meet the
unlimited wants of the society, it will eventually create a problem called,
“scarcity”.

If the problem of scarcity does not exist, there is no need for us to economize. But

since we know that our resources are limited and therefore we cannot produce all the

goods and services we cannot buy, then there is a need for us to study economics and

economist need to find other work.

You already know that individuals and groups within the society have innumerable

wants, there are available resources that can be utilized. However, since these resources

are limited, they are not freely available. Economics steps in to assist individuals and

societies in making proper choices – that is, the allocation and utilization of economic

resources, with the end in view of satisfying human wants for goods and services. Figure

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1.2 illustrates the relationship between available limited resources and unlimited wants of

man and society and the role of allocating these resources.

Figure 1.2 Economics

Limited Resources Unlimited Resources

Allocation

The figure depicts the relationship between available limited resources and
unlimited wants of man and society. It shows that when limited resources fail to
meet the unlimited wants of society, economics comes into play in order to
effectively and efficiently allocate resources.

Factors of Production. There are four economic resources which serve as inputs in

the production process. We refer to these resources as the factors of production and they

include the land labor, labor, capital, and entrepreneurship.

Below is a more comprehensive discussion of each factor.

Land. This broadly refers to all natural resources, which are given by, and found in

nature, and are, therefore, not manmade. It does not solely mean the soil or the ground

surface, but refers to all things and powers that are given free to mankind by nature. In this

sense, land comprises all the materials and things, which are available beneath the soil or

above it. It includes the forest, mountains, rivers, oceans, minerals, air, sunshine, light, etc.
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Land can sometimes be classified as a fixed resource. Land is the main source of raw

materials like timber, mineral, ores, etc., which are utilized in the production of goods and

services. The compensation for use of land is called rent.

Labor. Refers to any form of human effort exerted in the production of goods and

services. Labor covers a wide range of skills, abilities, and characteristics. It includes

factory or construction workers who are engaged in manual or physical work. It can also

refer to an economist, nurse, doctor, lawyer, professor and other workers and

professionals who are mainly involve in mental work.

The supply of labor in a country is dependent on the growth of its population and on

the percentage of the population that is willing to join the labor force. Naturally, a country

with a high population growth rate is expected to come up with a bigger labor supply, On

the other hand, the younger the population structure the higher will be the population who

will join the labor force. The compensation for labor rendered is salary or wage.

Capital. These are manmade goods used in the production of other goods and services. It

includes the building, factories, machinery, and other physical facilities used in the

production process.

Accordingly, a nation’s capital stock is dependent on its lever of saving.

Saving refers to that part of a person’s or economy’s income, which is not spent on

consumption. The reduction of productive capacity of capital is called depreciation. The

reward for the use of capital is called depreciation. The reward for the use of capital is

called interest.

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 At this point, we have to emphasize that money is not actually considered as capital

in economics as it does not produce a good or services but it is rather a form of assets that

is used mainly as a medium of exchange.

Entrepreneurship. A person who organizes, manages and assumes the risk of a firm,

taking a new idea or a new product and turning it into a successful business. Often times,

the entrepreneur is not presented as a separate factor of production but is classified as a

part of labor. However, since an entrepreneur performs a special type of work, which is

creation of goods and services, it should not be considered as part of labor.

Entrepreneurs also possess managerial skills needed in building, operating, and

expanding a business. Specially, he is one who decides what combinations of land, labor,

and capital are to be used in the production process. Entrepreneurship is an economic

good that commands a price referred to as

profit and lost.

The Circular Flow Model (WEEK 2)

Before we proceed further with our discussion, let us first look at how these

resources are utilized by the household and business sectors. We can simplify this

by illustrating it through the Circular Flow Model. The dynamics of market

economy creates continuous, repetitive flows of goods and services,

resources, and money. The circular flow diagram, shown in Figure 1.3, illustrate

the flow of resources and output from households to businesses, and vice

versa. Observe that the diagram we group private decision makers into businesses

and households and group markets into the resource market and the product market.

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 The upper half of the circular flow diagram represents the resource market: the

place were resources, or the service of resource suppliers are bought and sold. In

the resource market, households sell resources (i.e., land, labor, capital) and

business and use them in the production of goods and services. Households own all

economic resources either directly as workers or entrepreneurs or indirectly through

their ownership of business corporations. They sell their resources to businesses,

which buy them because they are necessary for producing goods and services. This

is represented by the inner arrow from the household sector going to the business

sector. The funds that businesses pay for resources are cost to businesses but are

flows of income in the form of wage, rent, interest, and profit to the households. This

is represented by the outer arrow from the business sector. Productive resources

therefore flow from households to business, and money flow from business to

household.

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Figure 1.3 Circular Flow Model

Wages and salaries,

rent, interest, profit
RESOURCE MARKET
Labor, land, capital,
entrepreneurial
ability

BUSINESSES HOUSEHOLD

Buy resources Sell resources

Sell products Buy products

Goods and services

PRODUCT MARKET
Consumption
expenditure

The figure illustrates the flow of resources and payments for their use as well as
the flow of goods and services and payment for them. Thus, the household
sector sells resources to and buys products from the business sector while the
business sector buys resources from and sells products to the household sector.

The lower half of the model represents the product market: the place

where goods and services produced by businesses are bought by the household. In the

product market, businesses combine the resources owned by the household (i.e., land,

labor, capital) to produce and sell goods and services. This is represented by the inner

arrow from the business sector going to the household sector. In return, the households

use the (limited) income they have received from the sale of resources to buy goods and

services that the business produced in the form of consumption expenditure. This is

represented by the outer arrow from the household sector going to the business sector.

The monetary flow of consumer (household) spending on goods and services yields sale

revenues for business. Businesses compare those revenues to their costs in determining

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profitability and whether or not a particular good or service should continue to be produced

and sold.

The circular flow model depicts a complex, interrelated web of decision making and

economic activity involving business and households. For the economy, it is the circle of

life. Business and household are both buyers and sellers. Business buy resources and sell

products. Households buy products and sell resources. As shown in Figure 1.3, there is a

counterclockwise real flow of economic resources and finished goods and services and

clockwise money flow of income and consumption expenditures.

What is the relationship between Economics and Scarcity?

If we will go back again to our previous discussion, we noted that the problem of

scarcity gave birth to the study of economics. Their relationship is such that if there is no

scarcity, there is no need for economics. The study of economics is therefore essential

in order to address the issue of resources allocation and distribution, in response to

scarcity. In the allocation of our limited resources however, we have to give up

something in order to get what we want. In other words, we cannot have everything

that we want because of the limited resources therefore something must be given

up or traded off. This brings us now to the concept of opportunity cost, one of the most

important economic concepts that you need to know and understand very well since all of

us try to apply this concept everyday of our lives.

The Concept of Opportunity Cost

Because people cannot have everything they want, they are forced to make

choices between several options. In making a choice people face opportunity cost. But

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what is opportunity cost? In economics, opportunity cost refers to the foregone value of

the next best alternative. In particular, it is the value of what is given-up is called the

opportunity cost of one’s choice.

When you make choices, there is always an alternative that you have to give up.

Moreover, a producer. Who decides to produce shoes, give up other goods that he could

have produced like bags using same resources. If you bought this book Microeconomics

with your limited allowance, you gave up the chance of eating out or watching movie or

playing computer games.

Opportunity cost however I expressed in relative price. This means that the price of

one item should be relative to the price of another.

Example:

If the price of Coke is P20.00 per can and one piece of cupcake is P10.00, then the

relative price of Coke is 2 pieces of cupcake. Therefore, If a consumer only has P20.00

and chooses to buy a bottle of Coke with it, then we can say that the opportunity cost of

that bottle of Coke was the 2 pieces of cupcake, assuming that the cupcakes were the

next best alternative. Figure 1.4 below further illustrates the concept of opportunity cost.

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Figure 1.4 Opportunity Cost

Saving (Firm/Individual)

Credit (Interest) Investment (Profit)

This figure illustrates the concept of opportunity cost. The savings of the

firm/individual is subject to two choices between credit and investment. If the

savings of an individual will be put on credit, there is possibility of earning

interest or a bad debt (not getting the money back), on other hand, when

savings of an individual is invested, it may earn profit or may be subject to loss.

With this in mind, what do you think is the best choice or next best alternative?

Basic Decision Problems

Below are some decision problems that households, firms, the government, and society

must think about in order to properly manage their resources. Regarded as economic

activities.

1. Consumption

Members of society, with their individual wants, determine what types of goods and

services they want to utilize or consume, and the corresponding amounts thereof

that they should purchase and utilize. The choices range from food, to shelter, to
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clothing, etc. There is also a choice between privately used goods or those supplied by

government, such as national security and defense, infrastructure, or irrigation.

Consumption is the basic decision problem that the consumers must always deal with their

day-to-day activities.

2. Production

The problem of production is generally a concern of producers. They determine the

needs, wants, and demands of consumers, and decide how to allocate their

resources to meet these demands. Goods and services may be produced by different

methods of production, depending on the firm’s technological state, and on the available

resources within the society.

3. Distribution

This problem is primarily addressed to the government. There must be proper

allocation of all the resources for the benefit of the whole society. In a market

economy, though, absolute equality of every member, as to distribution of resources,

can never be achieved.

4. Growth over Time

This is the last basic decision problem that a society or nation must deal with. Societies

continue to live on. They also grow in numbers. On the one hand, people have definite

lives, but societies (or nations) have longer, if not infinite lives. All the problems of choice,

consumption, production, and distribution have longer, if not infinite lives. All the problems

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of choice, consumption, production and distribution have to be seen in the context of how

they will affect future events.

Four Basic Economic Questions

To address the problem of scarcity and solve the basic decision problems, the society

must answer the four basic economic questions of what to produce?

For whom to produce? And How much to produce?

1. What to produce?

The question of what to produce tells us that an economy must identify what are the

goods and services needed to be produced for the utilization of the society in the

everyday life of man. A society must also take into account the resources that it

possesses before deciding what goods or services to produce.

For example, an island nation, blessed with agricultural resources and which does not

possess advanced technology should not opt to produce space shuttles or satellites

because its resources are incapable of producing these outputs. However, it can take

advantage of its natural resources and it can produce agricultural goods and tourism

services.

In market economy, what gets produced in the society is driven by prices. Resources are

allocated to the production of goods and services that have high prices and low input

prices relative to one another.

2. How to produce?

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 This questions tell us that there is a need to identify the different methods and

techniques in order to produce goods and services. In other words, the society must

determine whether to employ labor intensive production or capital intensive

production.

Labor intensive production uses more of the human resource or manual labor in

producing goods and services than capital resources. Generally, this kind of production is

advisable to a society with a large population. In countries where labor resources are

abundant and therefore there is high supply of labor, the cost of labor is usually cheap, for

instance the Philippines, Vietnam, and China.

On the other hand, capital intensive production employs more technology and capital

goods like machineries and equipment in producing goods and services rather than using

labor resources. This type of production is generally utilized by countries with high level of

capital stock and technology, and with scarce labor resources, like Japan, Germany, and

the USA.

The decision of what form of technology is to be employed depends more on the

availability of cheaper resources and less more expensive inputs. Thus, if there is

abundant supply of labor (capital) then this resource will be cheaper and will cost less so

production will be labor (capital) intensive.

3. How much to produce?

The question of how much to produce identifies the number of goods and

services needed to be produced in order to answer the demand of man and society.

The optimum amount of production must be approximated by producers.

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Underproduction (shortage) results to a failure to meet the needs and wants of the society.

On the other hand, overproduction result to excess (surplus) goods and service going to

waste.

4. For whom to produce?

This question identifies the people or sectors who demand the

commodities produced in society. Economist must determine the “target market” of

the goods and services which are to be produced to understand their consumption

behavior patterns. An understanding of these results to higher sales of goods, and

ultimately to increased profit. We can therefore say that for those who can pay the highest

price is for whom goods and services are produced.

There are 3 E’s in the study of Economics

Efficiency refers to productivity and proper allocation of economics resources. I t

also refers to the relationship between scarce factor inputs and outputs of goods

and services. This relationship can be measured in physical terms (technological

efficiency) or cost terms (economic efficiency) (Pass & Lowes 1993). Being efficient

in the production and allocation of goods and services saves time, money, and

increases a firm’s output. For instance, in the production of commodity, a firm utilizing

modern technology can improve the quantity and quality of its products, which ultimately

translates into an increase in revenue and

profit.

Effectiveness means attainment of goals and objectives. Economics therefore is an

important and functional tool that can be utilized by other field. For instance, with the use
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of both productions (through manual labor or through technological advancements),

whatever the output is, it will be useful for the consumption of the society and the rest of

the world.

Equity means justice and fairness. Thus, while technological advancement may

increase production, it can also bear disadvantages to employment of workers. Due to the

presence of new equipment and machineries, manual labor may not be necessary, and

this can result in the retrenchment or displacement of workers.

Positive and Normative Economics

Positive economics is an economic analysis that considers economic conditions “as

they are”, or considers economics “as it is”. It uses objective or scientific explanation

in analyzing the different transactions in the economy. It simply answers the question ‘what

is’.

Example of positive statements:

 The economy is now experiencing a slowdown because of too much

politicking and corruption in the government.

 The economy is now on a slowdown because the world is experiencing a financial

and economic crisis. Other reasons are also due to the financial problem of US,

increase in the prices of crude oil and lack of investors or capital deficiency.

On the other hand, normative economics is an economic analysis which judges economic

conditions “as it should be” It is that aspect of economics that is concerned with human

welfare. It deals with ethics, personal value judgments and obligation analyzing economic

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phenomena (Kapur 1997). It answers the question ‘what should be’ It is also referred to

as policy economics because it deals with the formulation of policies to regulate economic

activities (Omas-as 2008).

Example of Normative Statements:

 The Philippine government should initiate political reforms in order to regain

investor confidence, and consequently uplift the economy.

 In order to minimize the effect of global recession, the Philippine government

should release a stimulus package geared towards encouraging economic

productivity.

Ceteris Paribus Assumption

In economic analysis however we cannot consider all the factors that affect economic

situations or phenomena. Therefore, economists have devised a way of simplifying

complex economic phenomena through the assumption of “Ceteris Paribus.” This

assumption is important in studying economics. Popularized by economists, Alfred

Marshall (1824-1942) meaning “all other things held constant or all the else equal.”

This assumption is used as a device to analyze the relationship between two variables

while the other factors are held unchanged. It is widely used in economics as an

exploratory technique as it allows economist to isolate the relationship between two

variables. For instance, with the question: what is the impact of a change in the price of

rice on consumption behavior of the consumers, ceteris paribus (or other things remaining

constant)? If the price of the rice increases by 20 percent, how much consumption will

there be, assuming no simultaneous change in other variables – that is, assuming that

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income, number of family members, population, laws and so on all remain constant. The

remain constant. The setting of the other factor constant is what ceteris paribus is all about

since including the other factor in the analysis will make it complex and difficult for an

economist to explain the relationship between price and consumption behavior.

Microeconomics and Macroeconomics We have been talking about

individuals, firms or business, households, and society. But how do they differ? In order to

distinguish each of this, economics has two major branches of study: one is concerned

with individual decision making (microeconomics); and the other is involved in

understanding the behavior of the society as a whole (macroeconomics).

This learning module focused on Applied Economics which has the greatest demonstration

of Microeconomics is the branch of economics which deals with the individual decisions

of unit of the economy – firms and households, and how their choices determine relative

prices of goods and factors of production. In capitalist economy, the market is the central

concept of microeconomics. It focuses on its two main players – the buyer and the seller,

and their interaction with one another.

Microeconomics operates on the level of the individual business firm, as well as that

of the individual consumer. It concerns how a firm maximizes its profits, and how a

consumer maximizes his satisfaction.

Among the topics discussed in microeconomics are the principle of demand and

supply, elasticity of demand and supply, individual decision making, theories of production,

output and cost of firms, output and cost of firms, a firm’s profit maximization objective,

different types of business organizations, and kinds of market structure. (Case 2003)

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Types of Economic System. To address economic problems, several economic systems

have been created and applied throughout history. Below is an enumeration of these.

1. Traditional Economy is basically a subsistence economy. A family produces

goods only for its own consumption. The decisions on what, how, how much,

and for whom to produce are made by the family head, in accordance with

traditional means of production.

2. Command Economy is a type of economy, wherein the manner of production is

dictated by the government. The government decides on what, how, how

much, and for whom to produce. It is an economic system characterized by

collective ownership of most resources, and the existence of a central planning

agency of the state. In this system, all productive enterprises are owned by the

people and administered by the state.

An ideology, Socialism is an economic system wherein key enterprises are owned by

the state. In the system, private ownership is recognized. However, the state has control

over a large portion of capital assets, and is generally responsible for the production and

distribution of important goods. In a socialist economy, the main emphasis is on equitable

distribution of income and wealth. As such, it is considered as an economy bordering

between capitalism and communism.

3. Market Economy or capitalism’s basic characteristic is that the resources are

privately owned, and that the resources are privately owned, and that the

people themselves make the decisions. It is an economic system wherein most

economic decisions and means of production are made by the private owners.

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 Under this economic system, factors of production owned and controlled by

individuals, and people are free to produce goods and services to meet the demand

of consumer, who, in turn, are also free to choose goods according to their own

likes.

4. Mixed Economy is economy is a mixture of market system and the command

system. The Philippine economy is described as a mixed economy since it applies

a mixture of tree forms of decision-making.

However, it is more market-oriented rather than command or traditional.

Important Economic Terms

Economic has its own unique language. Thus for student to truly understand the

different concepts and theories in economics, an understanding of these term should first

be achieved.

Wealth

Wealth refers to anything that has a functional value (usually in money), which can

be traded for goods and services. Accordingly, wealth is the stock of net assets owned by

individuals or households. In aggregate term, one widely used measure of the nation’s

total stock of wealth is that of the ‘marketable wealth’, that is, physical and financial assets

which are in the main relatively liquid. (Pass & Lowes 1993).

Consumption

Consumption refers to the direct utilization or usage of the available goods and

services by the buyer (individual) or the consumer (household) sector.

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Production

Production is defined as the formation or creation by firms of an output (products or

services). It is basically the process by which land, labor and capital are combined in order

to produce outputs of goods and services.

Exchange

This is the process of trading or buying and selling of goods and/or its equivalent. It

also includes the buying of goods and services either in the form of barter or through

market.

Distribution

This is the process of allocating or apportioning scarce resources to be utilized by

the household, the business sector, and the rest of the world. In specific term, however, it

refers to the process of storing and moving products to customers often through

intermediaries such as wholesalers and retailers (Pass & Lowes 1993).

Brief Classical, Keynesian and History: The Modern Economics

This brief historical introduction aims to give a background on most profound

names in the study of economics and their important contributions in

this field of study.

Birth of Economic Theory: Classical Economics

Economic theory saw its birth during the mid 1700s and 1800s. During this era,

two important economist emerged. First is Adam Smith of Scotland, who is considered

the most important personality in the history of economics – being regarded as the “Father
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of Economics”. Among others, he was responsible for the recognition of economics as a

separate body of knowledge. His book,

“Wealth of the Nations”, published in 1776, became known as “the bible in economics” for

a hundred years (Fajardo 1977). One of his major contribution was his analysis of the

relationship between consumers and producers through demand and supply, which

ultimately explained how the market through the invisible hand.

Other important classical economist includes John Stuart Mill who was the heir to

David Ricardo, who developed the basic analysis of the political economy or the important

of a state’s role in its national economy. The term political economy is an older English

term that applies management to an entire polis (state). Karl Max, a German, also

emerged during this period. He is much influenced by the condition brought about by the

industrial revolution upon the working classes. His major work, Das Kapital, is the

centerpiece from which major socialist thought was to emerge. (Sicat 1983)

Neoclassical Economics (1870s)

Neoclassical Economics was believed to have transpired around the year 1870. Its

main concern was market system efficiencies. It brought recognition to such economist as

Leon Walras, who introduced the general economic system, and Alfred Marshall, who

became the most influential economist during that time because of his book Principle in

Economics. Leon Walras developed the analysis of equilibrium in several markets. On the

other hand, Alfred Marshall developed the analysis of equilibrium of a particular market

and the concept of “marginalism”. (Sicat 1939)

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Keynes’ General Theory of Employment, Interest and Money

John Maynard Keynes is an English economist who offered an explanation of

mass unemployment and suggestions for government policy to cure unemployment in his

influential book: The General Theory of Employment,

Interest and Money (1936). Keynes’ concern about the extent and duration of the

worldwide interwar depression led him to look for other explanation of recession. (Pass &

Lowes 1993)

In particular, Keynes argued that classical political economists were concerned

with the relative shares in national output of the different factors of production, rather than

the forces which determine the level of general economic activity, so that their theories of

value and distribution related only to the special case of full employment. Concerning upon

the economic aggregates of National Income, Consumption, Savings and Investment,

Keynes provided a general theory for explaining the level of economic activity. He argued

that there is no assurance that savings would accumulate during a depression and

depress interest rate, since savings depend on income and with high unemployment

incomes are low.

Furthermore, he argued that investment depends primarily on business

confidence which would be low during a depression so the investment would be unlikely to

rise even if interest rate fell, he argued that the wage rate would be unlikely to fall much

during a depression given its ‘stickiness’, and even if it did fall, this would merely

exacerbate the depression by reducing consumption.

24
Non-Walrasian Economics (1939)

During the Non-Walrasian Era, John Hicks was recognized for his analysis of the

IS-LM model, which is considered as an important macroeconomic model. IS refers to the

goods market for a given interest rate, while LM means money market for a given value of

aggregate output or income. The IS-LM model is theoretical construct that integrates the

real, IS (investmentsaving), and the monetary, LM (demand for, and supply for money),

sides of the economy simultaneously to represent a determinate general equilibrium

position for the economy as a whole (Pass & Lowes 1993).

Post-Keynesian Economic (1940 and 1950s)

After World War II, the Post-Keynesian Period saw the development of rules and

regulations of different private and public institutions. This period introduced major post-

Keynesian, neoclassical economist, whose views are known as the post-Keynesian

“mainstream economics”. This period welcomed various economist like Paul A.

Samuelson, Kenneth J. Arrow, James Tobin and Lawrence Klein, to mention some

recognized leaders; and other are Joan Robinson and Michael Kolechi. Another stream of

thought was introduced by liberal market post-keynesians, mainly the monetarists, led by

Milton Friedman. (Sicat 1983)

New Classical Economics

New classical Economics highlighted the importance of adherence to national

expectations hypothesis and analysis, which included various economic phenomena in

formulating different kinds of studies and new theories in economics. This development in

25
economics is applicable to concern for the growth for the growth of developed countries.

The great economist like Smith,

Ricardo and Malthus addressed this problem. (Sicat 1983)

LESSON 2: THE BASIC ANALYSIS OF DEMAND AND SUPPLY

Topics : Introduction

Methods of Demand Analysis

Forces that cause the demand curve to change

Occasional or seasonal products

Substitute and complementary goods

Expectations of future prices

Methods of Supply Analysis

Change in Quantity Supplied vs. Change in Supply

Optimization in the use of factors of production

Changes in Demand, Supply, and Equilibrium

Abstraction
Post Test

Activity Exercise

26
Duration : 15-hours
Lesson Proper

THE BASIC ANALYSIS OF DEMAND AND SUPPLY

Demand generally affected by the behavior of consumers, while supply is usually

affected by the conduct of producer. The interplay between these two is the foundation of

economic activity. Thus, the consumer identifies his needs, wants, and demands, while

producers address this accordingly producing goods and services. In the end, the

consumer gains satisfaction while the producer gain

profit.
As the economy cannot operate without this interaction between the consumer

and the produce, it is essential, therefore, that students understand the different

movements of the demand and supply curves, as well as the concept of market

equilibrium.

This chapter provides a discussion of the elements of demand and supply.

An understanding of these concepts is essential in the study of economics.

Demand

Demand pertains to the quantity of a good or service that people are ready

to buy at a given prices within a given time period, when other factors besides price are

held constant. Simply put, the demand for a product is the quantity of a goods and service

that buyers are willing to buy given its price at a particular time. Demand therefore implies

three things:

27
  Desire to possess a thing (good and service);

 The ability to pay for it or means of purchasing it (price); and  Willingness

utilizing it.

Market

Take note that when there is demand for a good and service, there is a market. A

market is where buyers and sellers meet. It is the place where they both trade or exchange

goods or services – in other words, it is where their transaction takes place. There are

different kinds of markets, such as wet and dry. Wet market is where people usually buy

vegetables, meet etc. On the other hand, dry market is where people buy shoes, clothes,

or other dry goods. However, in economic parlance, the term market does not necessarily

refers to a tangible area where buyers and seller could be seen transacting. It can

represent an intangible domain where goods and services are traded, such as the stock

market, real estate market, or labor market – where workers offer their services, and

employers look for workers to hire.

Methods of Demand Analysis

Demand can be analyzed in several ways. However, the most common way of

analyzing demand is through demand schedule, demand curve, and demand function.

Demand Schedule

A demand schedule is a table that shows the relationship of prices and the

specific quantities demanded at each of these prices. Generally, the information provided

28
by a demand schedule can be used to construct a demand curve showing the price-

quantity demanded relationship in graphical form. Table

2.1 presents a hypothetical demand schedule for rice per month.

Table 2.1

Hypothetical Demand Schedule for Rice Per Month

Situation Price (P)/kg. Quantity (kg)

A 35 8
B 24 13
C 13 20
D 12 30
E 11 45

The table shows the various prices and quantities for the demand for rice per month. For
instance, at a given price of P35 the buyer is willing to purchase only 8 kilos of rice (situation A);
however, at a price of P11, he is willing to buy 45 kilos of rice (situation E).

Take note that as the prices goes up (down) the quantity of rice being

purchased by the consumer goes down (up). This implies that quantity demanded is

inversely related with price. In other words, consumers are not willing to purchase more

rice at higher prices but will consume more if prices are low.

Demand Curve

As we have said earlier, the demand curve is a graphical representation

showing the relationship between prices and quantities demanded per time period. A

29
demand curve has negative slopes thus it slopes downward from left to right. The

downward slope indicates the inverse relationship between price and quantity demanded.

Observe that most demand curves slope downwards because (a) as the price

of the product falls, consumers will tend to substitute this (now relatively cheaper) product

for others in their purchase; (b) as the price of the product falls, this serves to increase

their real income allowing them to buy more products (Pass & Lowes 1993). Figure 2.1

illustrates a normal demand curve.

Figure 2.1 Demand Curve

D1
P1
D0
P0
D2
P2

D1

QD
0 Q Q0 Q2
1

The figure illustrates a typical demand curve.-axis

Therepresents
Y price (P) while -the
axisX
represents the quantity demanded (Q). The nddema
curve is negatively sloped or downward
sloping. The (negative) slope measures the change in quantity demanded for a unit change in
price. This indicates that as the price of commodities decreases (increases), more (less) goods
will be bought by the umer.
cons

Let us assume that the price of good A is at price P 0. At this price level,

quantity demanded for good A is at Q 0 and therefore demand will be at point D o along the

demand curve D1. However, if price will increase to P1 quantity demanded will decrease to

Q1 and demand will move upward towards point D1 along the same demand curve. The

30
reason why quantity demanded decreased after the price increased to P 1 is because of the

inverse relationship price and quantity demanded. Thus, in such situation, consumers will

purchase less of

good A at a higher prices than when it was at its original price P0.

But what will happen to quantity demanded if price will decline to say

P2? If you said quantity demanded will increase to Q2, then you are correct. Why? Because

as we can see in same figure, if price will decrease to P 2 quantity demanded will increase

to Q2 and demand will therefore be at point D 2. Observe again that the reverse happened

when price of good A declined to P2. In this case quantity demanded increased to Q 2.

Why? Because consumers will purchase more of Good A at a lower prices than when it

was at its original price

P0.

This bring us now to the Law of Demand which states that ‘if price goes UP, the

quantity demanded of a good will go DOWN’. Conversely, ‘if price goes

DOWN, the quantity demanded of a good will go UP ceteris paribus’. The reason for this is

because consumers always tend to MAXIMIZE SATISFACTION.

Demand Function

Demand can also be analyzed mathematically trough a demand function. A demand

function is also shows the relationship between demand for a commodity and the factors

that determine or influence this demand. These factors are – the price of the commodity

itself, prices of other related commodities, level of incomes, taste and preferences, size

and composition of level of population, distribution of income, etc. Demand function is

31
expressed as a mathematical function. Thus, we can show our mathematical function for

demand as:

QD = f (product’s own price, income of consumers, price of related goods,

etc.)

We can therefore come-up with the demand equation as:

QD = a – bP Where:

QD = quantity demanded at a particular price a =

intercept of the demand curve b = slope of the

demand curve

P = price of the good at a particular time period

We can now illustrate our demand function using a hypothetical example. Let us

assume that the current price of good A is P5.00. The intercept of the demand curve is 3

while the slope is 0.25. If we want to determine how much of good A will be demanded by

consumer X, we can simply substitute the given values to our equation, thus:

QD = 3 – 0.25 (5)

= 3 – 1.25

QD = 1.75 units of good A

But what if the price of good A will increase to P6.00? What will now be the new

quantity demanded by consumer X? If you say 1.5 units, then you are correct. Again by

simply substituting our values to our demand equation you will arrive at the new quantity

32
demanded. What happened to quantity demanded? There is a decrease of 0.25 units

because of the increase in price. Again, this is because of the inverse relationship between

price and quantity demanded.

Change in Quantity Demanded vs. Change in Demand

Before we go on further with our discussion of the concept of demand, let us first

distinguish change in quantity demanded and change in demand. This is important since a

change in quantity demanded must not be confused with a change in demand.

Change in Quantity Demanded

We can say that there is change in quantity demanded (symbolized as AQ D) if

there is a movement from one point to another point – or from one pricequantity

combination to another – along the same demand curve. A change in quantity demanded

is mainly brought about by an increase (a decrease) in the product’s own price. The

direction of the movement however is inverse considering the Law of Demand. shifted

downward or to the left (indicated by the arrow) from D to D’. If price remains at the same

level, demand for the product or service will decrease (from Q0 to Q1).

Increase (decrease) in demand is brought about the factors other than the price

of the good itself such as tastes and preferences, price of the substitute goods, etc.

resulting in the shift of the entire demand curve either upward or downward.

33
Figure 2.3 Change in Demand

P P

P P
0 0

D D
D D
0Q Q Q 0 Q Q Q
0 1 D 1 0 D

a. Increase in Demand b. Decrease in Demand

This figure shows the two different movements of the demand curve. Figure 3a shows an
increase in demand
, while Figure 3b illustrates a decrease or fall in demand.

Forces that cause the demand curve to change

There are several reasons why demand changes and thus cause the demand

curve to move either upwards or downwards. The following are the more general reasons

for the change in demand.

Taste or preferences

Taste or preferences pertain to the personal likes or dislikes of consumers for

certain goods and services. If taste or preferences change so that people want to buy

more of a commodity at a given price, then an increase in demand will result or vice versa.

As an illustration: Remember the craze for IPods? This came about in the

Philippines sometimes in 2006, and everyone just wanted to have one. At that time, there

were quite a number of MP3 player brands being sold in the market. However, for some

reasons consumers were just so engrossed with the thought of having an iPod MP3

player, to the point that some shops had all their stocks sold out. This is a clear example of

34
consumer preferences when it came to MP3 players during that time. Consumers

preferred a certain brand because at that time, it was “in” to have iPod. Consumer

preference towards a certain product increases the demand for that product. However,

products were consumers do not prefer, suffer a decrease in demand.

Changing incomes

Increasing incomes of households raise the demand for certain goods or services

or vice versa. This is because an increase in one’s income generally raises his capacity or

power to demand for goods

We can explain change in quantity demanded through a demand curve. Figure

2.2 below illustrates the concept of change in quantity demanded.

We can see in this figure that the original price is at P and at this price level quantity

demanded is at Q0. The point of interaction between P0 and Qo is at point along the

demand curve. Now let us assume that price decreases to P1. As a result quantity

demanded will increase to Q1 because of the change in the product’s price. As a result,

quantity demanded will move to point b along the same demand curve because of the

decrease in price as shown by the arrow. The reverse however will happen if price will

increase.

We can therefore say that there is a change in quantity demanded if the price
of the good being sold changes. This is shown by a movement from one point to another
point along the same demand curve.

35
Figure 2.2 Change in Quantity Demanded

P0 a

P1
b

D
0
Q0 Q1 QD

The figure illustrates the concept of change in quantity demanded. Change in quantity
demanded occurs when price of the product changes, thus, resulting to a change in quantity
demanded. This is illustrated in the graph above where P 0 declines to P1 resulting to change in Q0
to Q1 and a movement along the demand curve from point a to point b.

Change in Demand

There is a change in demand if the entire demand curve shifts to the right (left)

resulting to an increase (decrease) in demand due to other factors other than the price of

the good sold. At the same price, therefore, more amounts of a good or service are

demanded by consumers. Figure 2.3a illustrates an increase in demand. In the figure, we

can observe that the entire demand curve shifts upward or to the right (indicated by the

arrow) from D to D’. We can also observe that at the same price P 0 more goods will be

demanded by consumers (from Q0 to Q1).

Conversely demand decreases or falls if the entire demand curve shifts downward

or to the left. Thus, at the same price level, less amounts of a good or service are

demanded by consumers. A decrease in demand is illustrated in Figure 2.3b. We can

observe in the figure that the entire demand curve shifted downward or to the left

36
(indicated by the arrow) from D to D’. If price remains at the same level, demand for the

product or service will decrease (from Q0 to Q1).

Increase (decrease) in demand is brought about the factors other than the price

of the good itself such as tastes and preferences, price of the substitute goods, etc.

resulting in the shift of the entire demand curve either upward or downward.

Figure 2.3 Change in Demand

P P

P P
0 0

D D
D D
0Q Q Q 0 Q Q Q
0 1 D 1 0 D

a. Increase in Demand b. Decrease in Demand

This figure shows the two different movements of the demand curve. Figure 3a shows an
increase in demand, while Figure 3b illustrates a decrease or fall in demand.

Forces that cause the demand curve to change

There are several reasons why demand changes and thus cause the demand

curve to move either upwards or downwards. The following are the more general reasons

for the change in demand.

Taste or preferences
Taste or preferences pertain to the personal likes or dislikes of consumers for

certain goods and services. If taste or preferences change so that people want to buy

more of a commodity at a given price, then an increase in demand will result or vice versa.

37
 As an illustration: Remember the craze for IPods? This came about in the

Philippines sometimes in 2006, and everyone just wanted to have one. At that time, there

were quite a number of MP3 player brands being sold in the market. However, for some

reasons consumers were just so engrossed with the thought of having an iPod MP3

player, to the point that some shops had all their stocks sold out. This is a clear example of

consumer preferences when it came to MP3 players during that time. Consumers

preferred a certain brand because at that time, it was “in” to have iPod. Consumer

preference towards a certain product increases the demand for that product. However,

products were consumers do not prefer, suffer a decrease in demand.

Changing incomes

Increasing incomes of households raise the demand for certain goods or services

or vice versa. This is because an increase in one’s income generally raises his capacity or

power to demand for goods or services which he is not able to purchase at lower income.

On the other hand, a decrease in one’s income reduces his purchasing power, and

consequently, his demand for some goods or services ultimately declines.

Take for example Juan who is receiving a monthly salary of Php 10,000.00. He

loves to buy shirts during payday. With his income, he could only buy 3 shirts per month.

After a year, however, he was promoted to a higher position. Due to his promotion his

salary increased to Php 20,000.00 per month.

Because of the increase in Juan’s salary he can now afford to buy more shirts, say 6 shirts

per month. His capacity to buy more shirts (and other goods or services for that matter) is

simply the result of the increase in his monthly income.

38
Occasional or seasonal products

The various events or seasons in a given year also result to a movement of the

demand curve with the reference to particular goods. For example: During Christmas

season, demand for Christmas trees, parols, and other Christmas decors increases.

Moreover, demand for food items like ham and quezo de bola also increases. Similarly, as

Valentine’s Day approaches, the demand for red roses and chocolates also arises. It

should be noted, however, that after these events, demand for these products returns back

to the original level.

Population change

An increasing population leads to an increase in the demand for some types of good

or service, and vise-versa. This simply means that more goods and services are to be

demanded because of rising population. In particular, increase in population generally

result to an increase in demand for basic goods, such as food and medicines. On the other

hand, a decrease in population results in a decline in demand.

Substitute and complementary goods

Substitute goods are goods that are interchanged with another good. In a situation

where the price of a particular good increases a consumer will tend to look for closely

related commodities. Substitute goods are generally offered at cheaper price,

consequently making it more attractive for buyers to purchase. For instance, Juan wants to

buys a pair of Nike rubber shoes. But the price of the shoes that he wanted was worth

P5,000.00. Considering the price and his lower budget of P3000.00 he opted for an

39
alternative brand of shoes with a lower price, say Converse shoes. In this situation, Nike

and Converse shoes are lower

substitutes.
On the other hand, complementary goods are goods that compliment with each

other. In other words, one good cannot exist without the other good. For instance, your

pen cannot write if there is no ink in it or your cellphone cannot function if you do not have

a sim card or a load.

Expectations of future prices

If buyers expect the price of a good or service to rise (or fall) in the future, it may

cause the current demand to increase (or decrease). Also, expectations about the future

may alter demand for a specific commodity.

Take for example the fluctuation prices of rise. If households expect That a drastic

increase in the price of rice will happen after a week, their natural behavior is to purchase

and stock-up rice before the price goes up. Thus, at that given point in time there will be an

increase in demand for rice due to consumer stock piling because of the expected

increase in its future price.

Practical application of the concept of change in quantity demanded and change in

demand

Let us now consider some practical applications of the concept of change in quantity

demanded and change in demand, which you have earlier learned.

We already know that the price of gasoline in the domestic market tends to change

every now and then. Because of the price of gasoline in the domestic market tends to

40
change every now and then. Because of the price changes, private car owners tend to

lessen the consumption of gasoline during high prices by not using their cars, but tend to

increase their consumption during low prices by utilizing more their cars.

On the other hand, because of the increase in the price of gasoline, the sale of cars

has declined. This is because cars and gasoline are complementary goods so that the

increase in the price of gasoline will result in a decline in the sale of cars. Of course, cars

will not run without gasoline so that the higher the price of the gasoline. The reverse will

happen if the price of gasoline will decrease to say P30.00 per liter or even lower.

The first situation illustrates the concept of change in quantity demanded because

the only factor that causes the change was the price of gasoline. The second situation, on

the other hand, illustrates the concept of change in demand since other factors made the

demand to change.

Supply (Firm/Seller’s side)

We now go to the other side of the coin which is supply. Simply defined, supply is the

quantity of goods and services that firms are ready and willing to sell at a given price within

a period of time, other factors being held constant. It is the quantity of goods and services

which a firm is willing to sell at a given point in time. Thus, supply is a product made

available for sale by firms. It should be remembered that sellers normally sell more at a

higher price than at a lower price. This is because higher results to higher profits.

41
Methods of Supply Analysis

Just like demand, supply can also be analyzed through a supply schedule,

supply curve, and supply function.

Supply Schedule

A supply schedule is a table listing the various [prices of a product and the

specific quantities supplied at each of these prices at a given point in time. Generally, the

information provided by a supply schedule can be used to construct a supply curve

showing the price/quantity supply relationship in graphical form. Table 2.2 presents a

hypothetical supply schedule for rice per month.

42
Table 2.2

Hypothetical supply schedule for Rice Per Month

Situation Price (P)/kg. Quantity

A 35 48

B 24 41

C 13 30

D 12 17

E 11 5

The table shows the various prices and quantities for the supply for rice per

month. For instance, at a given price of P35 the seller is willing to sell 48

kilograms of rice (situation A); however, at a price of P11, he is willing to sell 5

kilograms of rice (situation E).

Observe that as price increases quantity supplied also increases. For instance, if

the price of rice per kilo is P35.00, sellers will be willing to sell 48 kilos of rice in the

market. However, if the price of rice will decrease to P11.00, sellers will be willing to sell 5

kilos of rice. As we have noted earlier, high prices provide incentives to sellers to sell more

because of the expected increase in their profits. However, when prices decline, these

43
become a disincentive on the sellers to sell more goods and services in the market since

their profits will be low.

Supply Curve

A supply curve is a graphical representation showing the relationship between

the price of the product sold or factor of production (e.g. labor) and the quantity supplied

per time period. The typical more (less) is supplied. This is illustrated in Figure 2.4.

Figure 2.4 Supply Curve

The figure illustrates a typical supply curve.

-axisThe
represent
Y the price
) (P

and the -X
axis represents the price (P) and
-axis
therepresents
X the quantity

supplied (Q
). The supply curve is positively sloped or upward sloping. This
s

positive slope indicates that as the price of commodities increases (decreases),

more (less) will be offered for sale by the producers.

goods

44
Let us assume that the price of good A is at P 0. At this price level Quantity supplied is at

Q0 so that our supply it at S0 in our supply curve S. Suppose the price of good A increases,

say to the level of P1. Definitely, quantity supplied will also increase, and in our illustration

this will be up to the level of Q 1. Therefore, supply will now be at S 1 in our supply curve.

Take note that at the new price P1 quantity supplied has increased to Q1. What is the

reason behind this? Again because of the direct relationship between price and quantity

supplied. Of course the reverse will happen if price will decrease to say P 2. Under this new

price, quantity supplied will only be at Q 2 so that supply will only be at S 2 in the supply

curve.

This now brings us to the Law of Supply. The law states that if the price of a good

or service goes up, the quantity supplied for such good or service will also go up; if the

price goes down the quantity supplied will also go down, ceteris paribus. The Law of

Supply implies that higher price is an incentive for business firms to produce more goods

or services as it will minimize their profits.

In particular, given the higher price, producers or sellers normally increase their

supply of goods or services to increase their profits. As such, they will always want that

prices of their goods are high. On the other hand, at a lower price only those producers or

sellers who are more efficient in their operations will survive. These producers or sellers

are those who are able to minimize their sources, who handle their budget well, and who

know how to handle these kinds of situations. Conversely other producers or sellers who

are less-efficient and with bad budgeting system will run the risk of losing profits or may

even be removed in the market (Sicat2003). This is what the Law of Supply means: that

45
higher price entices producers or sellers to supply more goods or services because of their

profit motive while lower price diminishes their goal of putting additional investment

because of the possibility of incurring a loss and taken out of the market.

Supply Function

A supply function is a form of mathematical notation that links the dependent

variable, quantity supplied (Qs), with various independent variables which determine

quantity supplied. Among the factors that influence the quantity supplied are price of the

product, number of sellers in market, price of factor inputs, technology, business goals,

importations, weather conditions, and government policies. Thus, we can transform our

statement in a mathematical function as follows:

Qs = f (product’s own price, number of sellers, price of factor inputs, technology,

etc.)

Given our supply function, we can now derive our supply equation:

Qs = a = bP

Where:

Qs = quantity supplied at a particular price a =

intercept of the supply curve b = slope of the

supply curve

P = price of the good sold

46
 We can now illustrate our supply equation using a hypothetical example.

Suppose the price of good A is P5.00. The intercept of the supply curve is 3 and the slope

of the supply curve is 0.25. If we want to know how much of good A will be supplied by

sellers, we can simply substitute the values in our supply equation. Thus,

Qs = a + bP

= 3 + 0.25 (5)

= 3 + 1.25

Qs = 4.25 units

But suppose the price of good A increase to P6.00, what will now be the quantity of goods

to be supplied by the seller? If your answer is 4.5 units, then you are correct. Why?

Because, as we have noted earlier, higher prices induce seller to sell more, so that in our

hypothetical example, when the price of good A increased to P6.00 the quantity supplied

increase to 4.50 units.

Change in Quantity Supplied vs. Change in Supply

Before we go on further with our discussion of the concept of supply, let us first

distinguish change in quantity supplied and change in supply. This is important since a

change in quantity supplied must not be confused with a change in supply.

47
Change in Quantity Supplied

A change in quantity supplied occurs if there is a movement from one point to another

point along the same supply curve. A change in quantity supplied is brought about by an

increase (decrease) in the product’s own price. The direction of the movement however is

positive considering the Law of Supply.

Figure 2.5 illustrates the concept of change in quantity supplied. As you can see in this

figure, the original price is at P0 and the corresponding quantity supplied is at Q0. The point

of interaction between P0 and Q0 is point a along the supply curve S. Now let us assume

that price increases to P1. As a result, quantity supplied will increase to Q 1. Quantity

supplied will therefore move from point a to point b along the same supply curve because

of the increase in price of the same product. The reverse however will happen if price will

decrease. A change in quantity supplied therefore happens if the price of the good being

sold in the market changes, and this is illustrated by a movement from one point to another

along the same supply curve.

48
Figure 2.5 Change in Quantity Supplied

The figure illustrates a change in

y supplied.
quantit Change in quantity supplied

happens when the price of the product changes, thus, resulting to a change in

quantity supplied. This is illustrated in the graph above

increases
wheretoPP
0 1

resulting to a change toin Q and a movementngalo

the same supply curve
0 1
Q
from point a to point
.
b

Change in Supply

A change in supply happens when the entire supply curve shifts leftward or

rightward. At the same price, therefore, less (more) amounts of a good or service is

supplied by producers or sellers. Figure 2.6a illustrates an increase in supply. In the figure,

we can see that the entire supply curve moves rightward (indicated by the arrow) from S to

S’. We can therefore observe that at the same price P 0 more goods will be offered for sale

by producers (from Q0 to Q1).

49
 On the other hand, supply decrease if the entire supply curve shifts leftward. At the

same price, fewer amounts of a good or service are sold by producers. A decrease in

supply is illustrated in Figure 2.6b. We can see in the figure that the entire supply curve

shifts leftward (indicated by the arrow) from S to S’. We can also see that at the same

price P0, supply for the product will decrease (from Q1 to Q0).

Increase (decrease) in supply is caused by factors other than the price of the good

itself such as change in technology, business goals, etc. resulting to the movement of the

entire supply curve rightward (leftward).

Figure 2.6 Change in Supply

P P
S S
S S
PO - - - - - - - - - ---------

Qs
Qs
0 Q0 Q1 0 Q0 Q1
a. Increase in Supply b. Decrease in Supply

The figure shows the two opposite movements of the supply curve when other factors

other than the price are the main causes. Figure 2.3a shows an increase in supply, while

Figure 2.3b illustrates a decrease or fall in supply.

Forces that cause the supply curve to change

Just like demand, there are also other factors that cause the supply curve to change.

Below are some of the factors that cause the supply curve change.

50
Optimization in the use of factors of production

An optimization in the utilization of resources will increase supply, while a failure to

achieve such will result to decrease in supply. Optimization in this sense refers to the

process or methodology of making or creating something as fully perfect, functional, or

effective as possible. Simply put, it is the efficient use of resources. In business parlance, it

can mean maximum production of output at minimum cost.

Thus, the optimization of the various factors of production i.e., land, labor, capital,

and entrepreneurship) results to an increase in supply, in the vice versa (Sicat 2003).

Technological change

The introduction of cost-reducing innovations in the production technology increase

supply on one hand. On the other hand, this can also decrease supply by means of

freezing the production through the problems that the new technology might encounter,

such as technical trouble (Samuelson and Nordhaus 2004).

Take for example AST Motors Corporation, which uses Machine “A” in the

production if its cars. Machine “A” can produce 20 cars per week. However, after 3 years

of production, AST Motors Corporation decided to replace Machine “B”, which can fully

produce 80 cars per week. Because of the introduction of this new technology (Machine

“B”), the quantity of cars supplied by AST Motors Corporation increased from 20 cars per

week to 80 cars per week. However, if

Machine “B” malfunctions and such was not fixed immediately, AST Corporation’s

production of cars would decrease and thus not meet the optimum level of production

using Machine “B”.

51
Future expectations

This factor impacts sellers as much as buyers. If sellers anticipate a rise in prices,

they may choose to hold back the current supply to take advantage of the future increase

in price, thus decreasing market supply. If sellers however expect a decline in the price for

their products, they will increase present supply.

For example: If MVB Meat Company expects a drastic increase in prices of meat

within the following week, it may opt to hold its supply of meat for the meantime and sell it

only upon application of the price increase, thus, reducing the present supply of meat in

the market.

Conversely, if NKR Company, a producer of pager, expects that its production will

be rendered obsolete after 2 years due to the introduction of cellular phones in the market,

it may decide to sell all its stock of pagers in order to presently earn profit from their sale,

rather than have them unsold in the following years, considering its apparent obsoleteness

in the near future.

Number of sellers

The number of sellers has a direct impact on quantity supplied. Simply put, the

more sellers there are in the market the greater supply of goods and services will be

available. For example, during the Christmas season, more tiangge more sell t-shirts and

RTWs resulting to an increase in the available shirts and RTWs in the market. Moreover, if

more farmers will plant rice instead of other crops , then the supply of rice in the market

will increase due to more production assuming that no destructive calamities will strike the

country.

52
Weather conditions

Bad weather, such as typhoons, drought or other natural disasters, reduces supply

of agriculture commodities while good weather has an opposite impact. For instance, if a

typhoon destroys the vegetable farm in Benguet Province, the supply of vegetables

particularly in the market of Metro Manila will decline.

Government policy

Removing quotas and tariffs on imported products also affect supply. Lower trade

restrictions and lower quotas or tariffs boost imports, thereby adding more supply of goods

in the market.

In order for imported products to be accepted in a country, there is a need for

importers to pay the government the required tariffs of duties and taxes.

Importers must also abide by the quota required by the government on certain products.

Quotas are limitation on the number or quantities of imported goods which could enter a

country. This is used in order to protect domestic or local products.

Market Equilibrium

From a separate discussion of demand and supply, we now proceed with

reconciling the two. The meeting of supply and demand results to what is referred to as

‘market equilibrium’. As earlier said the market referred to here is a situation ‘where buyers

and sellers meet’, while equilibrium is generally understood as a ‘state of balance’

53
Equilibrium

Market equilibrium generally pertains to a balance that exist when quantity

demanded equals quantity supplied. Market equilibrium is the general agreement of the

buyer and the seller in the exchange of goods and services at a particular price and at a

particular quantity. At equilibrium point, there are always two sides of the story, the side of

buyer and that of the seller.

For instance, given the price of P10.00 the buyer is willing to purchase 20 units. On

the seller side, he is willing to sell the quantity of 20 units at a price of P10.00. this simple

illustration simply shows that the buyer and seller agree at one particular price and

quantity, that is P10.00 and units. This is the main concept of equilibrium: that there is a

balance between price and quantity of goods bought by consumers and sold by sellers in

the market.

Equilibrium market price

Equilibrium market price is the price agreed by the seller to offer its good or

service for sale and for the buyer to pay for it. Specifically, it is the price at which quantity

demanded of a good is exactly equal to quantity supplied of the same good.

The equilibrium market price and quantity can best be depicted in graph. As

illustrated in figure 2.7, the demand curve depicts the quantity that consumers are willing

to buy at particular prices; the supply curve depicts the quantity that producers are

prepared to sell at particular prices. The equilibrium market price is generated by the

intersection of the demand and supply curves. A higher initial price (say at P40.00) result

in excess supply (QS = 200 units and QD = 100 units).

54
The excess supply is depicted by the area abc. In this case, the oversupply of 100 units

forces price down in order to eliminate the excess supply. At lower initial price (say at

P20.00) result in excess demand of 100 units (Q S=100 units and QD=200 units). This is

depicted by the area cef. In this case price is forced up in order to eliminate the excess

demand. Only at price P30.00 are demand and supply initiations fully synchronized.

What happens when there is market disequilibrium?

When there is market disequilibrium, two conditions may happen: a surplus or a

shortage may occur as shown in figure 2.7.

Surplus

Surplus is a condition in the market where the quantity supplied is more the

quantity demanded. When there is a surplus, the tendency is for sellers to lower market

prices in order for the good and services to be easily disposed from the market. This

means that there is a downward pressure to price when there is a surplus in order to

restore equilibrium in the market. This is depicted in Figure 2.7 by the arrow from point b

going down to the equilibrium point.

Generally, a surplus happens when there are more products sold in the market by

sellers but few products are bought by the customers. This is because the quantity of

goods that buyer are willing to buy at a given price is less than the quantity of goods that

sellers are willing to sell at the same price. This is shown in the illustration in Figure 2.7

where buyers are only willing to buy 100 units of good A when the price is at P40.00 so

that quantity demand is only at point a in our demand curve D. On the other hand, at the

same price level, sellers are willing to sell 200 units so that quantity supplied is at point b

55
of our supply curve S. Considering that quantity supplied at 200 units is greater than

quantity demanded at 100 units, there is an excess supply of 100 units of good A in the

market that are unsold. These unsold goods are the surplus in this particular situation,

which is illustrated by the point a, c, and b in our figure.

Now, how can be surplus of good A be eliminated? The way by which the surplus

can be eliminated in the market is by lowering the current price until it reaches the

equilibrium price, as shown by the arrow going down the equilibrium point c. In our figure,

the equilibrium price is P30.00 at point c and no other point in the figure shows that

quantity demanded is equal to quantity supplied. Under this situation it is the seller that

influences the lowering of the price until the equilibrium price and quantity are attained.

56
Figure 2.7 Equilibrium Market Price and Quantity

P S

50 Surplus
a b
40 -------------------------------------------
Equilibrium

30 -----------------------------

20---------------------------------------------- shortage
e f

10
D
0 Q
50 100 150 200 250 300

The figure shows the equilibrium between quantity demanded and quantity supplied (where X axis
represents the prices and Y-axis the quantities). The market equilibrium is the point of intersection between
the supply (S) and demand (D) curves, that is, at P = Q = 150. Any change in the price and quantity will result
to market disequilibrium, thus, when quantity demanded is less than quantity supplied a surplus occurs. On
the other hand, if quantity demanded is greater than quantity supplied, a shortage occurs.

Shortage

The reverse happens when shortage occurs in the market. Shortage is basically

a condition in the market in which quantity demanded is higher than quantity supplied at a

given price.

As you may have observed in Figure 2.7, a shortage exists below the equilibrium

point. In particular, a shortage happens when quantity demanded is greater than quantity

supplied at a given price. For instance, in our illustration at price P20.00 quantity

57
demanded for good A is at 200 units, which is at point f in our demand curve D. But at the

same price level quantity supplied for good A is only 100 units, which is at point e in our

supply curve. Why is this so? Because in this particular situation buyers are willing to buy

more at a lower price but sellers will only be willing to sell less since at lower price they will

only gain less profit. The shortage area in this situation is shown in the figure by the area

cef.

So, what happens when there is a shortage of goods and services in the market?

When there is a shortage of goods and services in the market, what happens is that there

is an upward pressure on prices to restore equilibrium in the market. In this particular

situation, it is the consumers that will influence that price to go up since they will bid up

prices in order for them to acquire the good or services that are in short supply. This is

depicted by the arrow going up from point e to the equilibrium point c. For as long as there

is disequilibrium in the market, prices will still go up until such situation is normalized.

Figure 8: Shortage in Demand and Supply

58
Changes in Demand, Supply, and Equilibrium

We already know that demand might change because of the factors other than the prices

of the goods and services sold like changes in consumers’ income, tastes and

preferences, and variation in the prices of related goods. Similarly, supply might also

change in response to changes in technology, cost of production, and government

policies. What effects will such changes in supply and demand have on equilibrium price

and quantity? This is now our concern here in this section: to show to you the effects on

equilibrium price and quantity when either demand or supply changes because of the

effect of the factors other than price.

Change in Demand

Supposed that the supply of some goods (say, bread) is constant and demand increase

(because of increase in income or change in the tastes and preferences of consumers for

example). This situation is illustrated in Figure 2.8. As you can observe in the figure, the

new intersection of the supply and demand curves is at higher values on both the price

and the quantity axes because of the shift of the demand curve upwards. Thus, from the

original E0 of P30.00 and 150 units, a new equilibrium point E, takes place at price P40.00

and quantity at 200 units.

Clearly, an increase in demand with supply remaining constant raises both equilibrium

price and quantity. Conversely, a decrease in demand with supply remaining unchanged

lowers both equilibrium price and quantity, as shown in our figure. (Of course, since you

are already familiar with reading and interpreting graphs, you can already figure out what

59
will be the new equilibrium price and quantity under this situation, all you need to do is to

compare the original equilibrium point and the new equilibrium point).

Figure 2.8 Change in Demand

The figure shows the effect of an increase in demand D ‘ to the equilibrium point, when

supply S remains constant. Generally, an increase in demand D ‘

results to higher price and quantity, as shown by D2.

Changes in Supply

What happens if the demand for some good (say, rice) remains constant but supply

increase (maybe because of change in technology or government policies), as shown in

Figure 2.9? As you can see in the figure, the new intersection of supply and demand is

located at a lower equilibrium point E1 at price P20.00 and at the higher equilibrium

quantity at 200 units.

60
We can therefore say that an increase in supply, generally results to a decrease in price

but an increase in the quantity of goods sold in the market. In constant, if supply

decreases while demand remains constant, the equilibrium price

increases but the equilibrium quantity declines. (Definitely, you can already figure out the

new equilibrium price and quantity under this particular situation).

Figure 2.9 Change in Supply

The figure shows the effects of an increase in supply S’ to the equilibrium point, when demand D remains
constant. Generally, an increase in supply S’ results to lower price but a higher quantity, as shown by E1.

Complex cases

When both demand and supply change, the effects is a combination of the

individual effects.

61
 Case 1: supply increase: demand decrease. What effect will a supply increase

and a demand decrease for some good (say mangoes) have on the equilibrium price? Can

you figure it out? Both changes decrease equilibrium price, so that the net results is a price

decrease greater than that of the resulting decrease from either change alone.

But, what about the effect on the equilibrium quantity? Here, the effects of the changes is

supply and demand are opposite: an increase in supply increases quantity but a decrease

in demand reduces it. The direction of the change in quantity depends upon the relative

sizes of the change in demand and supply. If the increase in supply is greater that the

decrease in demand, the equilibrium quantity will increase. But if the decrease in demand

is greater than the increase is supply, the equilibrium quantity will decrease. (You can

illustrate the situations in a graph so that you can figure out whether these situations are

correct).

Case 2: supply decrease; demand increase. A decrease in supply and an

increase in demand for some good (say gasoline) both increase price. Their combined

effect is an increase in equilibrium price more than that caused by either change

separately. But their effect on equilibrium quantity is again indeterminate, depending upon

the relative changes in supply and demand. If the decrease in supply is greater than the

increase in demand, the equilibrium quantity will decline. In contrast, if the increase in

demand is larger than the decrease in supply, the equilibrium quantity will increase. (Can

you illustrate the two situations in a graph? How do they look like?)

Case 3: supply increase, demand increase. What if both supply and demand

for some good (for example cell phones) increase? A supply increase lowers equilibrium

62
price, while a demand increase boosts it. If the increase in supply is larger than the

increase in demand, the equilibrium price will fall. However, if the opposite holds, the

equilibrium price will rise.

The effect on equilibrium quantity is certain: the increase in supply and in

demand each raise equilibrium quantity. Therefore, the equilibrium quantity will increase

by an amount greater than that caused by either change alone. (have you illustrated the

situations in a graph? Have you observed the changes?)

Case 4: supply decrease; demand decrease. What about decreases in both

supply and demand for some good (say black and white TV)? If the decrease in supply is

larger than the change in demand, equilibrium price will rise. However, the opposite is true

if the decrease in demand is greater that the increase in supply.

Since decreases in supply and demand reduce equilibrium quantity, we can

be sure that equilibrium quantity will definitely fall under these situations.

Price controls

When the market is experiencing a surplus there is a possibility that producers

will lose. Conversely, when the market is encountering shortage, there is likelihood that

consumers will be abused. What happens if disequilibrium

(either due to surplus or shortage) in the market persists at longer period of time?

If this happens, the government may intervene by imposing price controls.

Price control is the specification by the government of minimum or maximum

prices for certain goods and services, when the government considers it disadvantageous

63
to the producer or consumer. The price may be fixed at a level below the market

equilibrium price or above it depending on the objective in mind. In the former case, for

instance, the government may wish to keep the price of some goods (e.g. basic food)

down as a means of assisting poor consumers. In the latter case, the aim may be to

ensure that producers receive an adequate return (price support to farmers, for instance).

More generally, price controls may be applied across a wide range of goods and services

as part of prices and income policy aimed at combating inflation.

Price controls are classified into two types: floor price and ceiling price.

Floor price

A floor price is the legal minimum price imposed by the government on certain

goods and services. A price at or above the price floor is legal; a price below it is not. The

setting of a floor price is undertaken by government if a surplus in the economy persists.

For instance, the government may impose a minimum price on producers’ commodities

say at P40.00 as shown in Figure 2.10. Generally, this policy is resorted to in order to

prevent bigger losses on the part of the producers (e.g. farmers). Floor price is a form of

assistance to producers by the government for them to survive in their business. Floor

price are mainly imposed by the government on agricultural products especially when

there is bumper harvest or the labor market by imposing minimum wages.

64
 Figure 2.10 floor
price

The figures shows the equilibrium between quantity demanded and quantity

supplied at P30.00 and 150 units of goods.

mentIf govern
imposes a floor price of

P40.00, quantity demanded decreases to 100 units while quantity supplied

increases to 200 units resulting in a shortage of 100 units. In the long run, a floor

price will create surplus of goods in the market.

Observe in the figure that if the government imposes a price floor of say P40.00 producers

will sell 200 units of goods but consumers will purchase only 100 units of those goods.

Ultimately it results to a surplus of 100 units. In the long run, therefore, a floor price creates

an excess supply of goods since producers are enticed to produce more because of the
65
higher price but consumers are restrained from purchasing more of the good. A floor price

in the long run therefore distorts resource allocation and makes the product more

expensive since a floor price is imposed above the equilibrium price. Moreover, it makes

taxes higher in the long run since government has to finance its purchase of the surplus

product from the taxes collected from tax payers.

Price ceiling

A ceiling price is the legal maximum price imposed by the government. A price ceiling is

usually below the equilibrium price, for example at P20.00 as shown in the figure 2.11. In

most cases, a price ceiling is utilized by the government if there is a persistent shortage of

goods (e.g. basic commodities like food items and soil products) in the economy. As such,

the prices of goods affected by a shortage do not increase persistently. Because of this,

the government regularly monitors the market and imposes a maximum price on

commodities, which is to be strictly followed by producers and sellers.

A price ceiling therefore is imposed by the government to protect consumers from abusive

producers or sellers who take advantage of the situation. This is usually done by

government after the occurrence of a calamity like typhoon or severe flooding.

Take note however that in the long run, a ceiling price imposed by government results to

shortage of goods in the market. Why? Because at lower price producers do not have

enough incentive to produce more while consumers are encouraged to purchase more of

those goods. We can again illustrate this in the graph. For instance, in Figure 2.11 when

the ceiling price is set by the government at P20.00 producers are only willing to sell 100

units while consumers are enticed to buy more at 200 units. Consequently, a shortage of

66
100 units occurs in the market. Now, if government will continue to impose the price

ceiling, in the long run it will create greater shortage of the good in the market. As the

situation worsens, producers will now take advantage of the consumers by selling their

products at the higher prices in the illegal market (known as black markets). At this point,

consumers have no option but to buy the good at price higher than the ceiling set by the

government. Why can the producers increase their price (although illegally)? Because as

more consumers demand for the products, they will battle in out among each other in

buying the limited supply of goods available in the market brought about by the shortage

making the price go up. In other words, as the shortage of goods worsens in the long run,

more producers will sell their products at higher prices in the illegal market.

67
 Figure 2.11
Equilibrium of D and S with Price Ceiling

The figure shows theuilibrium

eq between quantity demanded and quantity

supplied at P30.00 and 150 units of goods. If government imposes a ceilings and

floor price of P20.00, quantity demanded increases to 200 units while quantity

supplied decreases to 100 units resulting

hortagein aofs100 units. In the
– long

run, a ceiling price will create shortage of goods in the market.

Could you think of concrete examples of price ceilings and floor prices imposed by

government? What do you think are the reasons why government imposes such price

controls?

68
Market Equilibrium: A Mathematical Approach

In the previous discussions, we have discussed and presented market equilibrium through

graphical presentation. In this section, we will try to apply mathematical equation in

determining the price and quantity equilibrium in the market.

You have already been introduced to the mathematical equation in determining demand
and supply when we presented this in our discussion of the demand and supply functions.
If you can still remember, the equation that we set are follows:

Demand equation: QD = a – b(P) (1)

Supply equation: QS = a + b(P) (2)
Equilibrium equation: QD = Qs (3)

Take note that in the said equations, there are three unknown variables: Q D, QS, P where

QD is quantity demanded, QS is quantity supplied, and P is Price. Moreover, the parameter

in equations (1) and (2) is a and the coefficient is b.

Given these equations, we can now determine the equilibrium price and quantity.

Example:

Look for the PE and QE given the following information:

QD = 68 – 6P

QS = 33+10P

Solving the problem, we can simply state our equilibrium equation as: a – b(P) =

a + b (P)

Substituting our values, we have:

69
68 – 6(P) = 33 + 10 (P)

Solving for the unknown (P), we simply group like terms, thus

68 – 33 = 10P + 6P

35 = 16P

Dividing both sides by 16, we get

P= 2.19

Now we have determined the price of the good. The next problem for us is to determine

the equilibrium quantity. Since we already know the price, all we have to do is substitute

the value of the price to our previous equations, thus:

68 – 6 (2.19) = 33 + 10 (2.19)

Solving the equation, our QD = QS is equal to 54.8 or we can set the value in whole

number. Therefore, the equilibrium quantity is equal to 55 units and the equilibrium price is

P2.19.

Now, it is your turn to complete the following table by solving the quantity demanded and
quantity supplied given the price. After you have completed the table you should also
indicate whether there is a surplus or shortage at the particular price level.
Price QD QS Surplus/

Shortage

70
3

LESSON 3: THE CONCEPT OF ELASTICITY

TOPICS: Elasticity of Demand

Price elasticity of demand

Interpretation of the Elasticity Coefficient

Income Elasticity of Demand

Cross price elasticity of demand

Elasticity of Supply

Extreme types of Supply Elasticity

POST TEST

Duration 15 hours
Lesson Proper

THE CONCEPT OF ELASTICITY

You may have wondered why there are goods that you purchase more(less) when

price becomes less (more) while there are goods that even if prices become too high

(low) still you purchase the same quantity of that good. If you have asked yourself why and

tried to look for an answer, you are actually trying to explain the concept of elasticity.

In this chapter you will learn the meaning of elasticity. You will also learn

71
why this concept is very important to our everyday decision making as a consumer.

Elasticity of Demand

The law of demand tells us that we will buy more of a good or service if the price

declines and less when the price goes up. But how much more or less of good or service

will buy given the change in price? The amount varies from product to product and over

different price ranges for the same product. It may also vary overtime and such variations

matter. Of course, in order to answer the question, economists have developed the

concept of elasticity to explain how consumers respond to changes in the factors that

affect demand.

You may have first encountered the term elasticity in your Physics subject, which

refers to the expansion or contraction of a physical matter such as rubber band. In

economics however elasticity means responsiveness or sensitivity. In general, elasticity

is the ratio of the percent change in one variable to the percent change in another variable.

It is a tool used by economists to measure the reaction of a function to changes in

parameters in parameters in a relative way.

Demand elasticity, in particular, is a measure of the degree of responsiveness of

quantity demanded of a product to a given change in one of the independent variables

which affect demand for that product. We can classify demand elasticity according to

factors that cause the change. Thus,

Price elasticity of demand is the responsiveness of consumer’s demand to

change in price of the good sold.

72
Income elasticity of demand is the responsiveness of consumer’s demand to a change

in their income.

Cross price elasticity of demand is the responsiveness of demand for a certain good, in

relation to changes in price of other related goods,

Price elasticity of demand

When we speak of the price elasticity of demand, we are dealing with the

sensitivity of quantities bought by a consumer to a change in the product price. Thus, this

concept describes an action that is within the producer’s control (keat and young 2006)

We can therefore define elasticity of demand as the percentage change in

quantity demanded caused by a 1 percentage change in price. Thus, we can derive price
elasticity of demand using the following equation:

Ed = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

You may have observed that the most common method used by economics

textbooks in the measurement of price elasticity of demand is the arc elasticity. The

formula for this indicator is:

Where:

Ep = Coefficient of arc elasticity (Elasticity Coefficient

Q1 = Original quantity demanded

73
Q2 = New quantity demanded

P1 = Original price

P2 = New price

The numerator of this coefficient (Q 2 – Q1), indicates the percentage change in the

quantity demanded. the denominator, (P2 – P1), indicates the percentage change in the

price.

We can illustrate the concept of elasticity through the following example:

Suppose we have the following price and quantity schedule for good A.

P Q

6 0
4 10
2 20
0 30

Assuming that we want to determine how consumers would react if the price of good A will

decrease. For instance, applying the demand elasticity formula, we can solve the elasticity

coefficient assuming that price will decrease from P6.00 to P4.00 and quantity demanded

increases from 0 to 10 units. Substituting the values to our formula, we have

10−0 4−6

EP

74
 EP = - |5|

Now, try solving the elasticity coefficient for the other price and quantity

combinations. Do they have the same elasticity coefficient? If your answer is no, then you

are correct since as the price of and quantity demanded for the good move from one level

to another, the elasticity coefficients also change.

As you may have observed, the computed value of the price elasticity is always

negative, although when we analyze and interpret the coefficient, we ignore the negative

sign thus only the absolute value is interpreted. What could be the reason for this? It is

always negative due to the very nature of the relationship of price and quantity demanded:

if price increases, less quantity change is negative, leading to a negative price elasticity of

demand. Conversely, if price falls , this negative value will lead to a negative price of

elasticity of demand value.

Interpretation of the Elasticity Coefficient

For economics, solving the elasticity coefficient is only a tool rather than an end in

itself. What is important to them (and to you also) is to understand the meaning of the

computed elasticity coefficient. Our concern now is how to analyze and interpret the

elasticity coefficient. Actually there are only certain rules to remember in analyzing and

interpreting the elasticity coefficient as you will note in the following discussion.

75
 Demand for a product is said to be inelastic if consumers will pay almost any price

for the product, while demand for a product may be elastic if consumers will only pay a

certain price, or a narrow range of prices, for the product. Inelastic demand means that a

producer or seller can raise prices without much hurting demand for its product and elastic

and will only buy it if the price rises by what they consider too much.

We already know that a fall in the price of a good results in an increase in the

quantity demanded by consumers. However, the demand for a good is elastic when the

change in quantity demanded is less than the change in price. Thus, we can say that

demand is inelastic if the computed elasticity coefficient is less than 1 (E P < 1). Generally,

goods and services for which there are no close substitutes are inelastic. Basic food items

(e.g. rice, pork, beef, fish, vegetables, etc.), medicines (like antibiotics), and oil products,

are some examples of goods that are inelastic. Goods that are vices like cigarettes are

likewise inelastic for the simple reason that those who smoke cannot easily refrain from

smoking so that if the price of cigarettes has been increasing, still smokers consume them.

Conversely, demand for a good is elastic if the change in quantity demanded is

greater than the change in price. Therefore, we can say that demand is elastic if the

computed elasticity coefficient is greater than 1(E p > 1). In general, goods and services

that have many substitutes which consumers may switch to are elastic. Clothes,

appliances, cars, among others, are examples of goods that are elastic.

76
Graphical illustration

The price elasticity of demand can also be analyzed graphically. Figure 3.1

illustrates an elastic demand curve while Figure 3.2 shows inelastic demand curve. Take

note the slope of the two demand curve.

We can observe in Figure 3.1 that the slope of an elastic demand curve is flatter.

Thus, the more the demand curve becomes horizontal the greater it becomes elastic. This

because the small change in price, say from P3.00 to P1.00. results to a larger change in

quantity demanded, say from 10 units to 35 units. Take note that broken line ab is shorter

than broken line bc.

This means that if demand is elastic more quantities of good is demanded when

price changes even by a small percentage. In this case, we can say that consumers

respond greatly to a small change in price.

On the other hand, we can see in Figure 3.2 that the slope of an inelastic

demand is steeper or more vertical. In fact, the more the demand curve becomes steeper

or vertical the greater it becomes it inelastic. This is so since the large change in price, say

from P3.00 to P1.00 results to a small change in quantity demanded, say from 15 units to

20 units. As illustrated in the graph, we can observe that the broken line ab is longer than

broken line bc implying that less quantities of a good is purchased even when there is a

large change in price of the good. Under this situation, we can say that consumers’

response in buying a good is lesser than the change in price.

At the extreme, demand can be perfectly price inelastic, that is, price changes

have no effect at all on quantity demanded. A perfectly inelastic demand curve is

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illustrated as a straight vertical line (see Figure 3.3a), thus as the figure illustrate, even

when price will increase by more than one hundred percent, still the amount of good that

will be bought will be the same. An example of good that may be perfectly inelastic is the

medicine for cancer patient.

On the other hand, demand can be perfectly price elastic, that is, any amount will

be demanded only at the prevailing price. However, if the price will increase by even a

miniscule amount or a very small percentage, consumers will not anymore purchase good.

A perfectly elastic demand is illustrated as a straight horizontal line (See Figure 3.3) an

example of a good that may be

perfectly elastic is a trip to the outer space.

Figure 3.1 Elastic Demand Curve

The figure illustrates an elastic demand curve. An elastic demand curve is

flatter than a typical demand curve. This is because a smaller change in price
(broken line ab) calls forth
eater
a grpercentage change in quantity demanded,
(broken line)bc
.

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 Now that we have described what elasticity is, let us examine the reason why

demand for some goods is elastic, whereas for others it is inelastic. The question therefore

is: what determi9ne elasticity? However, before we look into these reasons, we have to

remember that the elasticity for a particular product may differ at different prices. For

instance, although the demand elasticity for rice is low as its current price, it may not be so

inelastic at P70.00 to P75.00 per kilo.

Going back to our question: what determines elasticity? There are important

factors that influence demand elasticity including (a) ease of substitution; (b) promotion of

total expenditures; (c) durability of product which may include (i) possibility of postponing

purchase, (ii) possibility of repair, and (iii) used product market; and (d) length of time

period (Keat and Young 2006).

Accordingly, the most important determinant of elasticity of a produce is ease of

substitution. If there are many good substitute for the product sold in the market, elasticity

for that product will be high. Moreover, if the product itself is a good substitute for other

goods, its demand elasticity will also be high. However, the broader the definition of a

commodity, the lower its price elasticity will tend to become because there is less

opportunity for substitutes.

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 Figure 3.2 Inelastic Demand Curve

The figure illustrates an inelastic

demand curve. An inelastic demand curve is
steeper than a typical demand curve. This is because a large change in price
(broken line ab) calls forth a smaller change in quantity demanded (broken line
bc)
.

Another major determinant of demand of elasticity is the proportion of total

expenditures spent on the product. For example, if the current price of rice is P5.00 per

kilo and it will increase to P6.00 per kilo, we may shrug off the P1.00 increase since its

effects on our total expenditure is very negligible. However, for products like appliances,

and techno gadgets like cell phones, computers, and iPod, the situation may be entirely

different. Hence, we can expect that the demand elasticity for an air conditioning unit to be

considerably high than that for rice. Another reason for high elasticity of this products is

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that a new appliance purchased can be postponed because there is a choice between

buying and repairing. Faced with a higher purchase price, a consumer may choose to

repair his old appliance instead of purchasing a brand new product.

Lastly, as market broaden, more and more products substitution becomes possible.

Advances in mode of transportation and communication accompanied by decrease in their

cost have increased the size of market overtime.

Consequently, the numbers of substitutes competing for consumers’ demand has

increased. In fact, market have not only widened on a national scale, they have crossed

national borders brought about by increase in international trade due mainly to

international agreements like the World Trade Organization (WHO) and other regional

trade blocks like the ASEAN Free Trade Agreement among

ASEAN member countries and Asia-Pacific Economic Cooperation (APEC).

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Figure 3.3 Extreme Types
Demand
of Elasticity

Figure 3.3a illustrates a perfectly inelastic demand curve

It can be interpreted that at pricedemand

OP, is infinite; however, a slight rise in

price would result in fall in demand to zero.lso

It can
be interpreted
a from Figure
-

3.3a that at price P consumers are ready to buy as much quantity of the product

as they want. However, a small rise in price

ld wou
resist consumers to buy the

product.

Though, perfectly elastic demand is a theoretical concept and cannot be applied in the
real situation. However, it can be applied in cases, such as perfectly competitive market
and homogeneity products. In such cases, the demand for a product of an organization
is assumed to be perfectly elastic.

From an organization’s point of view, in a perfectly elastic demand situation, the

organization can sell as much as much as it wants as consumers are ready to purchase
a large quantity of product. However, a slight increase in price would stop the demand.

Perfectly Inelastic Demand:

A perfectly inelastic demand is one when there is no change produced in the demand of

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a product with change in its price. The numerical value for perfectly inelastic demand is

zero (ep=0).

In case of perfectly inelastic demand, demand curve is represented as a straight

vertical line, which is shown in Figure-3.3b

Figure 3.3b Perfectly elastic Demand

It can be interpreted from Figure-3.3b that the movement in price from

OP1 to OP2 and OP2 to OP3 does not show any change in the demand
of a product (OQ). The demand remains constant for any value of price.
Perfectly inelastic demand is a theoretical concept and cannot be
applied in a practical situation. However, in case of essential goods,
such as salt, the demand does not change with change in price.
Therefore, the demand for essential goods is perfectly inelastic.
. The figure

above are the two extreme types of demand elasticity. Figure 3.3a illustrates a perfectly inelastic

demand curve while Figure 3.3.b shows a perfectly elastic demand curve.

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Income Elasticity of Demand

Income elasticity of demand measures the degree to which consumers respond to a

change in their incomes buy purchasing more or less of a particular good. The coefficient

of income elasticity of demand E1 is determined with formula:

E1 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

In discussing income elasticity of demand, we have to distinguish a normal good

from an inferior good.

A good is considered a normal good if a rise in income brings an increase in

demand and a fall in income brings a decrease in demand. For most goods, the income

elasticity coefficient E1 is positive, meaning that more of them are demanded as income

rise. However, the value of E1 varies greatly among normal goods. For example, if you buy

more bottled water when your income increases, then bottled water is a normal good. Most

good are considered normal goods. In addition, if your income rises by 10 percent and it

resulted to a 15 percent increase in your demand for movies, your income elasticity of

demand for movies is 1.50 (equal to 15 percent ÷ 10 percent). We can therefore say that a

good is a normal good if the income elasticity is positive – indicating a positive relationship

between income and demand. New cars, new techno gadgets, new clothes are some of

the products that have positive income elasticities and are thus considered normal goods.

In the other hand, a good is an inferior good if a rise in income brings a decrease in

demand and a fall in income brings an increase in demand. In other words, the

consumption of other products decreases (increases) as income increases (decreases).

84
For these goods, the income elasticity is negative – revealing a negative relationship

between income and demand. Hence, a negative income elasticity coefficient designates

an inferior good. Used clothing, home cooked food, riding a jeepney are some examples of

goods that have negative income elasticity. Consumers of these goods decreases their

purchases as their income rise.

Cross price elasticity of demand

We already noted in our previous discussions that the demand for a particular

product also depends in part on the prices of related goods – substitutes and

complements. The cross price elasticity of demand measures the responsiveness of

demand to changes in the prices of other goods, indicating how much more or less of a

particular product is purchased as other prices change. The cross elasticity is defined as

the percentage change in quantity demand of one good (X) divided by the percentage

change in the price of a related good (Y). Thus, the formula for cross price elasticity of

demand is:

Exy

As we have already noted, two goods are considered substitute if there is a

positive relationship between the quantity demanded of one good and the price of the

other good. For example, an increase in the price of bananas increases the demand for

mangoes as consumers substitute mangoes for bananas. For a more specific example,

suppose the price of a burger falls by 10 percent and the demand for pizza decreases by 5

percent, the cross price elasticity of demand for pizza with respect to the price of burger is:

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 Exy = -5 percent ÷ 10 percent = 0.50

The cross price elasticity of demand for a substitute is positive. A fall in the price of a

substitute good brings forth a decrease in the quantity demanded of the good. In other

words, the quantity demanded of a good and the price of one of its substitute change in

the same direction.

Supposed that when the price of Coke falls by 10 percent and the quantity of pizza

you demanded increased by 2 percent. The cross elasticity of demand for pizza with

respect to the price of Coke is:

Exy = +2 percent ÷ -10 percent = -0.20

Two goods are considered complements if there is a negative relationship between

the quantity demanded of one good and the price of the other good. Hence, the cross price

elasticity of demand for a complement is negative: a fall in the price of a complement

brings forth as increase in the quantity demanded of the other good. In other words, the

quantity demanded of a good and the price of one of its complements change in opposite

directions.

Estimates of cross elasticity of demand are useful to retailers in their pricing

decisions. For example, when a grocery store cuts the price of bread, the store will sell

more bread but will also sell more complementary goods such as jelly, peanut butter,

cheese, ham, etc. If the cross elasticity of demand for jelly is 0.5. a 10 percent decrease in

the price of bread will increase the demand for jelly by 5 percent. Retailers use coupons

for one product to promote the sales of that good as well as its complementary goods.

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Armed with the relevant cross elasticities, retailers can predict just how much more of a

complementary goods consumer will buy.

Elasticity of Supply

Supply elasticity refers to the reaction or response of the sellers or producers to

price changes of goods sold. In other words, it is a measure of the degree of

responsiveness of supply to a given change in price. Moreover, it is the percentage

change in quantity supplied given a percentage change in price.

Thus, Es

Supposed the price of rice increases from P20.00 to P22.00, the quantity supplied

increases from 100 million metric tons to 120 million metric tons. In other words, a 10

percent increase in the price of rice increased the quantity supplied by 20 percent using

the formula for the supply elasticity.

If a percentage change in price results in a more than proportionate change in

quantity supplied, then quantity supplied is said to be price elastic.

(See Figure 3.4). take note that an increase in the price of good A from P1.00 to P3.00

represented by the broken line ba results in a larger increase in quantity supplied from 5

units to 25 units represented by the broken line cb. This simply indicates that the

response of suppliers to a small change in price is to increase the quantity of goods

supplied in the market more than the increase in price. Just like an elastic demand curve.

In fact, the more the supply curve tends to be horizontal the more that it becomes highly

elastic.

87
 P S

Figure 3.4 Supply Elastic

The figure illustrates an elastic supply curve. An elastic supply curve is flatter than a

normal supply curve. This is because a smaller change in price (broken line) calls for a

greater change in quantity supplied (broken line cb).

Conversely, if a change in price produces a less than proportionate change in the

quantity supplied then supply is considered price inelastic (See Figure 3.5). Observe in the

figure that an increase in the price from P1.00 to P3.00 represented by the broken line ba

resulted in a small increase in quantity supplied from 5 units to 10 units represented by the

broken line cb. The small change in quantity supplied simply tells us that suppliers are not

that responsive to price changes under an inelastic supply condition. We can also see that

inelastic supply curve is more vertical than a normal supply curve. In fact, the more vertical

the supply curve is the more it becomes a highly inelastic.

At the extremes, supply can be perfectly price inelastic, that is, price changes have

no effect at all on quantity supplied. A perfectly inelastic supply curve is illustrated by a

straight vertical line ( See Figure 3.6a). On the other hand, supply can be perfectly price

88
elastic, that is, any amount will be supplied at the prevailing price. A perfectly elastic

supply curve is a straight horizontal line (See Figure 3.5).

P S

Figure 3.5 Supply inelastic

This figure illustrates an inelastic supply curve. An inelastic supply curve is more

vertical than a normal supply curve. This is because any change in price (broken line ba)

calls forth a smaller change in quantity supplied (broken line cb)

Just like demand elasticity, what determines supply elasticity? Two important

factors can be identified: (a) time; and (b) time horizon involved with which production can

be increased.

Time is a determinant of supply elasticity as producers respond to changes in prices from

time to time, given a certain period. Some producers change the number of supply of their

commodities depending on the movements of prices which shifts from time to time.

Also, the degree of responsiveness of supply to changes in price is affected by the time

horizon involved in the production process. In the short run, supply can only be increased

89
in response to an increase in demand or price by working on the firms’ existing plant more

intensively, but this usually adds only marginally to total market supply. Hence, in the short

run, the supply curve tends to be price inelastic. Why? Because when the price of a

particular in their existing production facilities (for example, in their factories, stores,

offices, etc.). Although higher price will certainly induce firms’ production facilities. In the

long run, firms are able to enlarge their supply capacities by building additional plants and

by extending existing ones so that supply conditions in the long run tend to be more price

elastic. Moreover, new firms can enter the market so there will be a larger response in the

long – run. As time passes, supply becomes more elastic as more and more new firms

have the time to build production facilities and produce more output.

Figure 3.6 Extreme types of Supply Elasticity

The figures above the two extreme types of supply elasticity. Figure 3.6 illustrates a

perfectly inelastic supply curve shows a perfectly elastic supply curve.

Now that you have clear idea why some goods that you purchase are more (less) than the

price changes, it is now time for you to apply the concept that you have learned in your

everyday activity as a consumer. It is expected that this concept will help you in your

decision making as a consumer (and may be later on as a producer).

There are three extreme cases of PES. Perfectly elastic,where supply is infinite at any

one price. Perfectly inelastic, where only one quantity can be supplied. Unit elasticity,

which graphically is shown as a linear supply curve coming from the origin.

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 Figure 3.6 Extreme types of Supply Elasticity

LESSON 4: CONSUMER BEHAVIOR AND UTILITY MAXIMIZATION

TOPICS: Goods and Services

Consumer Goods

Essential or Necessity Good Vs. Luxury Goods

Economic and Free Good

Tastes and Preferences

Maslow’s Hierarchy of Needs

The Economics of Satisfaction

The Utility Theory

91
 Marginal Utility Total Utility

Duration: 6 hours

CONSUMER BEHAVIOR AND UTILITY MAXIMIZATION

We, as a consumer, are unique in many ways. We have different needs, wants and

demands. We differ in likes and dislikes, standards, reactions, lifestyles, traditions, etc.

However, our behavior as a consumer is hard to identify and measure. From an economic

stand point, our objective as consumers is to maximize our satisfaction given our limited

budget (or income). With this in mind, economics seeks to explain why consumers behave

differently and in a particular manner.

In this chapter, you will learn how we as consumers behave in order to maximize our

satisfaction on the goods and services that we consume given our limited income.

Consumer

Before we proceed with our discussion of consumer behavior, let us first define who is a

consumer. Simply defined, a consumer is one who demands and consumes goods and

services. Without, consumption (mainly by households), there is no need for production

made by firms. The consumer is the king in a capitalists or free-market economy.

Producers, for their own interests, have to satisfy the needs and wants of consumers in

order to earn profits. In this perspective, all of us are consumers because as we live our

daily lives we demand goods and services the moment we wake up in the morning until we

retire to our bed at night.

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 As consumers, our power is to determine what are to be since we are the ultimate

purchasers of goods and services. This is referred to as consumer sovereignty. In general

terms if we, as consumers, demand more of a good or service then more of it will be

supplied or vice versa. The producers simply obey the wishes and desires, and the needs

and wants of consumers. This therefore implies that producers are’ passive agents’ (Pass

and Lowes 1993) in the price system because they simply respond to what we want.

However, in certain kinds of market (notably oligopoly and monopoly), producers are so

powerful vis-à-vis consumers that it is they who effectively determine the range of choice

open to us consumers. Nevertheless, our freedom to satisfy our human wants is not

completely unlimited. For the good of society and the individual consumers, the

government restricts consumer sovereignty. For example, the government prohibits the

use of dangerous drugs and substances and regulates the use of products that are health

hazards like alcoholic beverages and cigarettes. It also regulates products that are

destructive to the environment like the use of leaded gasoline.

Goods and Services

It is also important to clarify first what are goods and services. Goods refer to anything that

provides satisfaction to the needs, wants, and desires of the consumer. They can be any

tangible economic products9 like cars, books,

clothes, cell phones, iPods, etc.) that contribute directly (final goods) or indirectly

(intermediate goods) to the satisfaction of human needs and wants. Services, on the other

hand, are any intangible economic activities (such as hairdressing, catering, insurance,

93
banking, telecommunications, etc.), that likewise contribute directly or indirectly to the

satisfaction of human wants.

Tangible goods can be classified according to, but not limited to, the following:

Consumer goods

These are the goods that yield satisfaction directly to any consumer. These goods are

primarily sold for consumption, and not to be used for further processing or as an input or

raw material needed in producing another good. Usually, these are the goods that are

easily accessible to consumers (for example, soft drinks, bread, crackers, cellular phone

loads, clothes etc.).

Essential or necessity good vs. luxury goods

Essential or necessity goods are goods that satisfy the basic needs of man. In other

words, these are goods that are necessary in our daily existence as human beings. These

are also goods that we cannot live without such as food, water, shelter, clothing, electricity,

medicine, etc.

Conversely, luxury goods are those which men do without, but which are used to

contribute to his comfort and well-being. Examples of luxury goods are private jet, yacht,

luxury cars, perfumes, jewelry, etc.

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Economic and free good

An economic good is that which is both useful and scarce. It has value attached to it and a

price has to be paid for its use. If a good is so abundant that there is enough of it to satisfy

everyone’s need without anybody paying for it, that goods is free.

Water from our faucet is an economic good, because we are not utilizing it for free, we

have to pay to its distributor. The air that we breath and the sunlight coming from the sun

are examples of free good.

Tastes and Preferences

Consumes have various tastes and preferences. Generally, tastes and preferences are

determined by age, income, education, gender, occupation, customs and traditions as well

as culture. Preferences are the choices made by us consumers as to which products or

services to consume. The strength of our preferences will determine which products to buy

given our limited disposable income and thus the demand of products as well as which

product to buy. We as consumers also express preferences as to which particular brand of

a product to purchase. Even in the choice of food, clothing and shelter, for instance, we

differ in our choices and preferences. Some prefer bread than rice, others like fish and

vegetables than meat. In fact, we can generalize that no two consumers have exactly the

same likes and dislikes. Some individuals have simple taste and few preferences; others

are sophisticated and extravagant.

Before we leave this discussion, it is also important to understand what brand is. Simply

defined, a brand is the name, term or symbol given to a product by a supplier in order to

distinguish his offering from that of similar products supplied by competitors. Brand names

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are used as a focal point of product differentiation between suppliers. Examples of brand

names include Coca cola for the soft drink products; Guess, Levi’s, and Lacoste for RTW

products, etc. Now, you can identify other brands that you usually buy or consume?

Maslow’s Hierarchy of Needs

Maslow’s hierarchy of needs identifies the basic priorities of every consumer. Maslow saw

human needs in the form of a hierarchy, ascending from the lowest to the highest. He

concluded that when one set of needs is satisfied, this kind of need ceases. The basic

human needs placed by Maslow in an ascending order of importance (like a pyramid) are:

(a) social needs; (b) security, or safety needs; (c) social needs; (d) social needs; and (e)

self-actualization needs.

Physiological needs

These are the basic needs for sustaining human life itself, such as food, water, warmth,

shelter, sex and sleep. According to Maslow, until these needs are satisfied to the degree

necessary to maintain life, other higher order needs will not stimulate people.

Safety needs

These are the needs to be free of physical danger and the fear of losing one’s work

property, food, or shelter.

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Social needs

These needs cover the value of the sense of belongingness, love, care, acceptance and

understanding of family, relatives and friends, and to be accepted by others.

Esteem needs

These needs explain the importance of self-esteem, recognition, status of an individual

and the general acceptance of the society to an individual. This kind of need produces

such satisfaction as power, prestige, status, and self-confidence.

Self – Actualization needs

These needs explain the worth of a person’s self – development, growth and realization

and achievement. According to Maslow, this is the highest need in the hierarchy. It is the

desire to become what is capable of becoming – to maximize one’s potential and

accomplish something.

The Economics of Satisfaction

You might be wondering by now how economics can explain the behavior of consumers in

order to attain maximum level of satisfaction on the goods and services that they generally

consume. In this section we try to explain how consumers attain maximum satisfaction

level on the many goods and services available to them for consumption. However, we

have to remember at this point that satisfaction is a relative term. This is because we differ

in the way we are satisfied as well as the degree of our satisfaction. As we said earlier, no

two consumers have the same likes and dislikes. This section will discuss to you some of

97
the theories that economists have devised to explain how consumers are able to attain

level of satisfaction when consuming a particular good or service.

The utility theory

Utility, in economics, refers to the satisfaction or pleasure that an individual or consumer

gets from the consumption of a good or service that (s)he purchases. For purposes of

economic analysis, utility is also measured by how much a consumer is willing to pay for a

good/service.

Table 4.1 presents a hypothetical demand schedule for siopao. You will notice in the table

that the amount of money that you are willing to buy for an additional unit of siopao

declines. What is the reason for this? As you might have experienced the more siopao you

can eat, the more you become satiated so that you are not willing to spend more for the

next siopao that you wish to consume. In other words, the satisfaction or utility that you

derive in the consumption of an additional siopao declines as you consume more and

more of it.

The hypothetical example that we just illustrated is what the utility theory is all about. It

simply tries to explain how our satisfaction or utility as consumer’s decline when we try to

consume more and more of the same good at a particular point in time.

Two important concepts need to be explained before we totally understand the utility

theory. These are: the marginal utility and total utility concepts.

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Marginal utility is defined as the additional satisfaction that an individual derives from

consuming an extra unit of a good or service. Marginal; means’ additional’ or ‘extra’. In

economics, we use marginal analysis in the examination of the effects of adding one extra

unit to, or taking away one unit from, some economic variable. For this purpose, we are

interested in the incremental or additional utility derived from an additional consumption of

a commodity. Thus, the marginal utility of a commodity is the increase in total utility or

satisfaction derived from the consumption of an additional or extra unit of such commodity;

is the loss of utility or satisfaction if one unit less is consumed. In other words, it is the

change in the total utility that results from a one-unit increase in the quantity of a good

consumed.

Table 4.1

Hypothetical Demand Schedule for Siopao

Price Quantity Demanded

(P) (QD)
15.00 1
12.75 2
10.50 3
8.25 4

The table shows that as you continue to buy siopao, your willingness to pay for it

continuously declines because your satisfaction from the good declines as you consume

more of it.

Total utility, on the other hand, is the total satisfaction that a consumer service derives

from the consumption of a given quantity of a good or service in a particular time period.

99
We can also say that utility is the total benefit that a person gets from the consumption of a

good or service. Total utility depends on the quantity of the good consumed – more

consumption generally gives more total utility. Hence, our total utility usually increases as

we consume more and more of a good or service, but generally the increase is at a slower

or declining rate. This implies that each extra unit consumed adds less and less marginal

utility than the previous units consumed as we become satiated with the good or service

we are consuming.

Let us illustrate this using the hypothetical utility schedule presented in Table 4.2 Assume

that the end of our class, you are too hungry so that you went directly to the cafeteria. In

the cafeteria, you bought and consumed one siopao for your merienda. In this case, your

total and marginal utilities are 40 utils. Assume further that you consumed another siopao

because you are too hungry after the class. Your total utility now increases to 90 utils so

that marginal utility increases by 50 utils. Let us now assume that you have consumed five

siopaos. Take note in that table that your total utility for the fifth unit is 350 utils. However,

what is more important is the marginal utility. As we can observe, marginal utility has

declined to 80 utils. Why is this so? This is because of the Law of Diminishing Marginal

Utility.

GLOSSARY

Allocation - A description of who does what, the consequences of their actions, and who

gets what as a result (for example in a game, the strategies adopted by each player and

their resulting payoffs).

100
Allocation rate - The percentage of the money you pay into a pension scheme or life

insurance policy that is actually invested.

Asset - Anything of value that is owned. See also: balance sheet, liability.

Ceteris paribus - Economists often simplify analysis by setting aside things that are

thought to be of less importance to the question of interest. The literal meaning of the

expression is ‘other things equal’. In an economic model it means an analysis ‘holds other

things constant’

Commodities - Physical goods traded in a manner similar to shares. They include metals

such as gold and silver, and agricultural products such as coffee and sugar, oil and gas.

Sometimes more generally used to mean anything produced for sale

Consumer sovereignty - is the idea that it is consumers who influence production

decisions. The spending power of consumers means effectively they ‘vote’ for goods.

Economics - The study of how people interact with each other and with their natural

surroundings in providing their livelihoods, and how this changes over time.

Economic goods – cover goods, services, products and the like that have price and are

sold in a market

Economic Resources- inputs used in the production of goods and services

Employment rate - The ratio of the number of employed to the population of working age.

Entrepreneur - A person who creates or is an early adopter of new technologies,

organizational forms, and other opportunities.

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Equilibrium - A model outcome that does not change unless an outside or

external force is introduced that alters the model’s description of the situation.

Equity - An individual’s own investment in a project. This is recorded in an individual’s or

firm’s balance sheet as net worth. See also: net worth. An entirely different use of the term

is synonymous with fairness.

Excess demand - A situation in which the quantity of a good demanded is greater than

the quantity supplied at the current price.

Excess supply - A situation in which the quantity of a good supplied is greater than the

quantity demanded at the current price.

Exchange – this is the process of trading goods and/or services for money and/or its

equivalent.

Goods – anything that yields satisfaction to someone

Income - The amount of labour earnings, dividends, interest, rent, and other payments

(including transfers from the government) received by an economic actor, net of taxes

paid, measured over a period of time, such as a year.

Investment (I) - Expenditure on newly produced capital goods (machinery and equipment)

and buildings, including new housing.

Invisible hand game - A game in which there is a single Nash equilibrium and where

there is no other outcome in which both players would be better off or at least one better

off and the other not worse off.

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Marginal utility - The additional utility resulting from a one-unit increase of a given

variable.

Market - A way that people exchange goods and services by means of directly

reciprocated transfers (unlike gifts), voluntarily entered into for mutual benefit (unlike theft,

taxation), that is often impersonal (unlike transfers among friends, family).

Monopoly - A firm that is the only seller of a product without close substitutes.

Also refers to a market with only one seller.

Needs - the things that we need for survival

Oligopoly - A market with a small number of sellers of the same good, giving each seller

some market power.

Opportunity cost - The opportunity cost of some action A is the foregone benefit that you

would have enjoyed if instead you had taken some other action B. This is called an

opportunity cost because by choosing A you give up the opportunity of choosing B. It is

called a cost because the choice of A costs you the benefit you would have experienced

had you chosen B. The opportunity cost of some action A is the foregone benefit that you

would have enjoyed if instead you had taken some other action B.

Product market = refers to a place where goods and services are bought and sold

Resource market - is a place, either physical or virtual, where materials, assets and other

elements are exchanged between parties. In other words, supply and demand interact with

each other to trade different kinds of items.

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Scarcity – it is a commodity or service being in short supply. A good that is valued, and for

which there is an opportunity cost of acquiring more.

Saving - When consumption expenditure is less than net income, saving takes place and

wealth rises.

Share - A part of the assets of a firm that may be traded. It gives the holder a right to

receive a proportion of a firm’s profit and to benefit when the firm’s assets become more

valuable. Also known as: common stock.

Shock- An exogenous change in some of the fundamental data or variables used in a

model.

Supply curve - The curve that shows the number of units of output that would be

produced at any given price. For a market, it shows the total quantity that all firms together

would produce at any given price.

Wants - the things that we would like to have

Wealth – refers to anything that has a functional value which can be traded for goods and

services. It constitute Stock of things owned or value of that stock. It includes the market

value of a home, car, any land, buildings, machinery, or other capital goods that a person

may own, and any financial assets, such as bank deposits, shares, bonds, or loans made

to others. Debts to others are subtracted from wealth—for example, the mortgage owed to

the bank.

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