EARLY ECONOMIC THEORIES
productive as each worker becomes more
A theory is defined as a well substantiated
explanation of some aspects of the natural
world.
An organized system of accepted
knowledge that applies in a variety of
circumstances to explain a specific set of
phenomena.
Economic Theory is defined as a theory on
commercial activities such as the
production and consumption of goods.
Malthusian Theory of Population growth
Thomas Robert Malthus, an English cleric
and scholar, examined the relationship
between population growth and resources.
Example, if every member of a family tree
reproduces, the tree will continue to grow
with each generation.
On the other hand, food production
increases arithmetically, so it only increases
at given points in time.
According to Malthus, if left unchecked,
populations can outgrow their resources.
Adam smith and the wealth of nations
Adam Smith, a Scottish economist and
philosopher, was a pioneer in political
economy and modern economics.
His best known work, An Inquiry into the
Nature and Causes of the Wealth of
Nations, was published in 1776.
The book offers a detailed description of
life and trade in English society and also
scientifically describes the basic principles
of economics.
Economic ideas of adam smith
Productivity and Wealth.
Smith observed that labor becomes more
skilled at a single job.
He said that the new machinery and the
division and specialization of labor would
lead to an increase in production and
greater wealth for the nation.
He also argued that wealth was the sum of
the nations’ goods produced by labor,
regardless of who owned those goods.
Invisible Hand.
One of Smith’s most important
contributions deals with the competition in
the marketplace.
He argued that competition, together with
the free market system, would act as an
invisible hand that would guide resources
to their most productive use.
He believed that under competitive
conditions, individuals acting naturally in
their own self-interest, and with minimum
of government intervention, would bring
about the greatest good for society as a
whole.
Laissez-Faire.
The Wealth of Nations was ridiculed by
aristocracy in Parliament at that time.
Business people, however, were delighted
to have a moral justification for their
growing wealth and power.
Eventually, the doctrine of laissez-faire,
meaning no government intervention in
economic affairs, became the watchword of
the day in Great Britain.
What is free market?
The laissez-faire is a doctrine that claims
that an economic system should be free
from government intervention or
moderation, and be driven only by the
market forces.
Centered on the belief that human beings
are naturally motivated by self-interest and,
when they are not interfered – within their
economic activities, a balanced system of
production and exchange based on mutual
benefit emerges.
Keynesianism
John Maynard Keynes, a British economist,
spearheaded a revolution in economic
thinking that overturned the then-
prevailing idea that free markets would
automatically provide full employment –
that is, that everyone who wanted a job
would have one as long as workers were
flexible in their wage demands.
The main plank of Keynes’ Theory, which
has come to bear his name, is the assertion
that aggregate demand – measured as the
sum of spending by households, businesses,
and the government – is the most
important driving force in an economy.
Keynesianism – the revolutionary idea
Keynes argued that inadequate overall
demand could lead to prolonged periods of
high unemployment
According to Keynesian economics, state
intervention is necessary to moderate the
booms and busts in economic activity,
otherwise known as the business cycle.
Keynesianism – Three principle tenets
Aggregate demand is influenced by many
economic decisions – public and private.
Therefore, Keynesian economics supports a
mixed economy guided mainly by the
private sector but partly operated by the
government.
Prices, and especially wages, respond
slowly to changes in supply and demand,
resulting in periodic shortages and
surpluses, especially of labor.
Changes in aggregate demand, whether
anticipated or unanticipated, have their
greatest short-run effect on real output and
employment, not on prices.
MODERN ECONOMIC THEORIES
CONSUMERISM states that an increasing
consumption of goods is economically
beneficial.
LIBERALISM advocates free competition
and a self-regulating market.
MONETARISM states that variations in
unemployment and the rates of inflation
are usually caused by changes in the supply
of money.
UTILITARIANISM bases the moral worth of
an action upon the number of people who
derive happiness or pleasure from it. It is
used when making social, economic, or
political decisions for the “betterment of
society”.
ECONOMIC METHODOLOGY
Some Economic Problems
Unemployment - Leads to the existence
of idle resources
Economic Instability - Results to
difficulty of producers to make accurate
forecasts on demand and consumption
levels.
Low Levels of Growth & Development -
Poor countries get caught in the vicious
cycle of poverty
Inequality in Income Distribution -
Causes pyramidal structure in the
economy
Determination of the type of economic
system - To know the manner in which
goods will be produced, the quantities
of these goods, and the distribution
process
ECONOMIC ANALYSIS
- The process of directing economic
relationships by examining economic
behavior and events and determining
the causal relationships among the data
and activities observed.
Economic Tools
* Logic (student) - The first tool of
economics. Inductive/Deductive
Reasoning.
* Statistics (analyst) - To quantitatively
describe economic behavior and serve
as basis in hypothesis testing.
* Mathematics - Enables an analyst to
foresee and assess a hypothesis for
empirical validation.
Purposes of Economic Analysis
1. An aid in understanding how
economy operates because it explains
how economic variables are related to
one another.
2. It permits prediction of the results of
changes in the economic variables.
3. It serves as a basis for just policy
formulation.
ECONOMIC POLICY
* Consists of intervention or courses of
action taken by the government or other
private institutions to manipulate the
results of economic activity.
* May be monetary, fiscal, or trade for the
purpose of achieving economic welfare.
* monetary – control of the quantity of
money available in an economy and the
channels by which new money is supplied.
* fiscal – use of government spending and
taxation to influence economy.
* trade – affects the number of goods and
services a country exports and imports.
METHODOLOGY
* Economic Theory consists of sets of
principles or causal relationships among
the important facts or variables that
surround and permeate economic
activity.
* Look first on the constructions and
functions of sets of economic principles,
then look at the overall framework of
the economic discipline.
THE CONSTRUCTION OF ECONOMIC
THEORY
* Any set of principles or theories must
have a fundamental starting point,
consisting of propositions or conditions
that are taken as given (without further
investigation).
* These are premises or postulates
upon which the theory is established.
Step 1. Specify and define the
postulates
Step 2. Observe facts concerning the
activity about which to theorize
Step 3. Apply the rules of logic to the
observed facts in an attempt to
establish causal relationship and
eliminate irrelevant and insignificant
facts
Step 4. Test the formulated hypotheses
* Some hypotheses will not withstand * Ending extreme poverty
the rigors of repeated testing and must * Boosting shared prosperity
be rejected.
FACTORS CONSIDERED IN BUILDING AN
* Others may look promising with ECONOMY
modifications and others may be found
to hold up so they are relevant. These * Saving and Investment
are now the principles. - To ultimately allow for increased
public savings, a reduction in
Measuring the National Income unemployment which will reduce
poverty levels is needed.
Accounts
- To reduce unemployment, promotion
ECONOMIC GROWTH
of both domestic and foreign
- It boosts the national output, the total
investments must be done.
money value of all goods and services
produced by one country
* Diminishing Returns and Catch-up
- It directly boosts development; all
Effect
other things remain constant, as higher
- As the stock of capital increases, the
GDP would mean more to spend on
extra output produced from an
factors that are considered
additional unit of capital decreases.
development.
- Productivity is considerably affected
ECONOMIC DEVELOPMENT
minimally when the workers with a
- It means advancement of the standard
large quantity of capital they use in the
of living, e.g., education, healthcare,
production process are given extra units
innovation, environment, to name a
of capital.
few.
- In the long run, a higher saving rate
STANDARD OF LIVING
leads to a greater level of productivity
- It is the level of consumption that
and income but not greater growth in
people enjoy, on the average, and is
these variables.
measured by the average income per
person.
* Investment from Abroad
- An investment that is sponsored with
COST OF LIVING
foreign money and operated
- It is the amount of money it takes to
domestically is called foreign portfolio
buy goods and services that a typical
investment.
family consumes.
- A rising cost of living is called inflation
- The World Bank (WB) and the
and deflation is otherwise.
International Monetary Fund (IMF)
were established to ensure that there is
ECONOMIC GROWTH
economic prosperity around the world
- In 2013, the World Bank Group adopted
by financing public goods and services
the twin goals to guide its work in
addressing issues concerning productivity with funds accumulated from more
and living standards: advanced economies like the United
States of America (USA).
* Education
- Human capital theory attributes
differential investments in human
capital to inequalities in income, such as
those found to exist between women
and men or minorities and whites.
- The theory emphasizes human capital
as a set of economic assets.
* Health and Nutrition
- A healthy population would also mean
human capital.
- A country is capable to produce more
goods and services because they can
maximize employment as compared to
an unhealthy population.
- Other things remain fixed, healthier
individuals are more productive.
* Property Rights and Political Stability
- Property rights ensure the exercise of
rights over one’s property and these
guarantee more production of goods
and services.
- A stable political environment is
considered to have efficient executive,
legislative, and judiciary systems,
working together for the country’s
economic development.
* Free Trade
- A competitive economy that reduces
or eliminates trade restrictions
experiences economic growth after
benefitting from more products to be
used as input to production.
- Outward-oriented policies give way to
developing countries’ opportunity to
interact with other countries and trade
freely, thus creating more prospects to
improve production.
* Research and Development
- The products of research and
development (R&D) are new ideas,
goods, and services that people
consume.
- Government institutions allocate a
part of their yearly budget to research
to continue improving the way things
are done, in a more efficient or totally
distinctive way.
- Essentially, R&D turning money into
knowledge and innovation is a process
of creating a business out of this
knowledge.
* Population Growth
Two schools of thought:
1. A relatively large population means
more human resources working and
contributing to the production of the
country.
2. It also means more people to
consume those goods and services.
PRODUCTIVITY
Productivity Factors
1. Physical Capital - Assets that
are utilize to produce goods and
services.
2. Human Capital - Knowledge,
skills and abilities (KSA) humans
develop.
3. Natural Resources - Refers to
the bounty of the land and water
used in production.
4. Technology - Innovation and
advances to make life easier and
more efficient production.
* Productivity means the amount of cannot be replaced by ten people who
goods and services produced from each sing the videoke.
unit of labor.
* The key factor in defining the Assumptions:
standard of living is the advances in * There is one worker for every task
productivity. (variable W)

* The level of quality is within the range of

* GDP seen in two ways: the total cost
zero to 10, with 10 being the highest quality
of expenses that a country spends on
The O-Ring Production Function is
goods and services and the economy’s “Output”, O = WX(Q1 X Q2 X … QiX … Qw)
income as its output

O-RING THEORY OF
DEVELOPMENT

Proposed by economist Michael Kremer

in 1993.

Explains that production is composed of

a set of tasks, and each task must be
carried out proficiently for each one of
the tasks to have value.

The name was derived from the

devastating destruction of the
Challenger space shuttle in 1986,
resulting from a faulty little gasket or O-
Ring. SOLOW MODEL

Explains the discrepancy of the One of the most popular model in

developed and underdeveloped
countries in terms of the complexity of
their production, product intricacies,
and the level of skilled workers that
they have.
A weak link in the production process
may cause a surmountable quality
failure of the final output.
The quality of input is given more value
that its quantity.
neoclassical economics used to
understand long-term growth.
Originated by Robert Solow, an
American economist and a Nobel Prize
winner in Economic Sciences.
Developed in 1956 wherein gross
domestic product per worker, capital
per worker, depreciation rate, savings
and investment rates are factored in
analyzing growth.

Example, a highly skilled chef of a

It focused on capital and labor, where
restaurant cannot be replaced by two
technology is exogenously included.
or three cooks or a great opera singer
y = Af (K,L)
where y is GDP growth rate, A is the
total factor productivity, f is a function
and represents technology, K is capital,
and L is labor.
y = f (K,AL)  technology augments
labor
y = F (AK,L)  technology augments
capital
y = AF (K,L)  effect of A to y is called
Solow residual. It works independently
of capital and labor.

The standard Solow Model is used to

estimate that in the long run,
economies converge to the steady-state
equilibrium.

We can use the Solow Model on the

following assumptions:

That we are analyzing with a closed

economy in mind, where savings is
equal to investment. Labor, L, and
capital, k, are sustainable for each
other.

Capital depreciates at a fixed rate, as

well as the population, it grows at a
constant rate, there is full employment
of labor, there is diminishing return to
an individual output and the most
notable is that there is no technological
progress going on.