Chapter 1

The Nature and

Process of Economics

The nature and process of economics affect all of us everyday. From the moment we
wake up in the morning till we sleep at night, even during the time that we are asleep, economic
activity is unfolding.

If you are an ordinary worker, or a student, or a professional that came from the
province but is presently living in the city for your own purpose, then you would know that you
reached the city by taking a plane, for sure, you spent for this travel, either by yourself or by
somebody else.

While in the city, you will have to look for a place to stay: a bed space, a room, or an
apartment and pay rent.

You go to the mall, buy the things that you need, go to the movie houses and other
entertainment centers; these are activities that require payment. You are to pay for your
purchases both for goods and services.

Did you ever wonder why all these things becomes possible; that you don’t need to
produce nor to create things that you need for yourself? You realize that others produced and
created these things for you. Again, this is the question: Why do people produce and create
goods and services for other people? What motivates them? How all these things reach the mall
in a very orderly manner? What about the prices? Why do the prices differ from one another?

The answer to these questions and more are properly addressed and studied.

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Why study Economics?
Below are reasons why we need to study Economics:

1. To study Economics is to learn a way of thinking. A way of thinking is a process by

which you are guided by the concepts from which a good decision is derived.

2. A study of Economics is also an essential part of the study of the society where e live in.
Changes continue to affect life today. A good view of where we live in. Changes
continue to affect life today. A good view of where we are now and where we are going,
what do we have and else can we have in the future what determines the character of our
society.

3. An understanding of Economics is an integral part of understanding global affairs. All

countries are part of world economy. If one country is producing nuclear weapons,
others are weary of its effect. If the Philippines decides to reject an offer of the U.S., it
will have an impact on our economic relations with them.

4. A participation in the political process is an issue that is motivated by Economics. If you

elected one candidate this May 2010, it can be thought that your choice was based on
one among the many premises that your life will improve economically because job
opportunities will be available.

Presentation of Microeconomic Structure

2
 As knowledge concerning social relationships is accumulated. It may be systematically
classified into a body of general truths that will provide a formulation of general laws that must
be tested and verified. When a systematic arrangement and analysis of this body knowledge is
accomplished, it becomes a science. When the body of knowledge is concerned with social
phenomena, social sciences results. If the social phenomena in question are concerned with
relationships of production and exchange. Then the social science is Economics.

Economics as a Distinct Field of Study

Economics is a social science which is commonly defined as a branch of knowledge that
prescribes how limited resources may be efficiently allocated and utilized to equitably satisfy
the unlimited human wants and basic needs, In the study of economics, decision makers on the
production and consumption sectors of society are guided to make wise choices from the
numerous options that are available to them given certain production and consumption situation.

The most fundamental concepts that need to be properly understood are: opportunity
cost, marginal analysis and efficient market. These concepts will be introduced as the topics are
developed throughout this book.

In the Adam Smith’s An Inquiry to the Nature and Causes of Wealth of Nations in 1776,
Smith is primarily concerned with the factors which lead to increased wealth in the community,
and rejected the Physiocrat’s view of prominent position of agriculture in the economy,
recognizing the parallel contribution of manufacturing industry. The work of Adam Smith
became the foundation upon which was constructed the whole subsequent tradition of English
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Classical Economics from the time of David Ricardo. He began his analysis by means of a
sketch of a primitive society of hunters. If it costs twice the labour to kill a beaver as it does a
deer, one beaver would exchange for two deers. Labor was the fundamental measure of value,
through actual prices of commodities were determined by supply and demand on the market.

He suggested that there are two elements in the problem of increasing wealth:
1. The skill of the labour force; and
2. The proportion of productive to unproductive labour.

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 Aside from knowing the fundamental concepts and elements suggested by Smith, it
is also important to recognize the different aspects of economics:

1. It is a social science because it deals with relationships among individuals and

groups in a society. Thus, it must constantly be interacted with other social sciences
such as sociology, psychology, and political science. Often times, it has to borrow
certain premises from these other sciences.

2. It is concerned with the choices we make. Value judgements regarding the needs of
man and of society are completely indispensable to the task of devising solution to
economic problems. As long as value judgements are made clear and explicit, the
scientific nature to economic inquiry can still be relied upon.

3. It is concerned with a society’s material welfare. In primitive societies the

economizing habit is part of the instinct of survival. But in more complex societies,
greater rationality is demanded of individuals if they are to satisfactorily solve their
problems in scarcity.

We note that the problem of economics arises from the very scarce resources and the
never ending wants and desires of human. The resources of society consist not only of
nature’s gift such as land, forest and minerals but also human resources, both mental and
physical, and all sorts of man-made aids to further production, such as tools, machinery and
building. Resources are agents of production because the resources of society are to produce
those things that people desire in order to satisfy their wants. The things that people produce
are called commodities. Commodities may be divide into goods and services where in the
former are tangible and the latter are intangible. Goods and services are therefore a means
by which individuals get satisfied out of their consumption. The process of converting new
materials into finished goods is production.

Importance of economics
The study of economics can give the student a better view of complexity of society
where he lives as well as the conceptual framework of the important decisions and choices
he may wish to take. A moulding process in understanding human survival is to appreciate
the reality that economic resources are scarce, and therefore need to be judiciously allocated
and properly used.

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Macroeconomic versus Microeconomics
The field of economics is generally divided into two major parts.

1. Macroeconomics. Examines the performance of an economy as a whole. It

focuses on the behaviour of economic indicators in aggregates, such as national
income and output, employment situation, inflation and general price level; and
taxation situation and the extent of government involvement of economy.

2. Microeconomics. On the other hand, examines the workings of individual

industries and the framework of decision-making by individual players of the
economy, principally, the households and the business firms. It also discusses the
role of price in the efficient allocation resources.

Microeconomics deals with how an individual consumer spends his income to

maximize satisfaction, how business combines resources or factors of production to
maximize profit and minimize losses and how the price of commodity and each type of
resource is determined by demand and supply. It studies how these individual decisions are
affected by different forms of market organization.

Economics aims to develop theories, principles and models which are abstractions
and generalizations of reality that can be applied to resolving or alleviating specific
problems and in furthering the realization of society’s overall goals. The goal is to develop
policies that might prevent or correct such macroeconomic problems as inflation and
unemployment, and microeconomic problems such as poverty, population explosion,
pollution and urbanization.

When we study the income or expenditure of an individual bank, we are dealing with
microeconomics. But when we deal with total income and total expenditures of the whole
banking industry, then we are engaged in the study of macroeconomics. If we discuss
specific industry crisis in our country, we are concerned with the microeconomics analysis.
However, what is true in microeconomics may not be true to macroeconomics. For example,
an eggplant farmer gets harvest. This means more income for him. But f all eggplant
farmers increased their harvests, it is not favorable to them, because more supply reduces
the price of eggplants.

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 Chapter 2
Demand, Supply,
and Market

Price is the primary determinant of demand. Hence, in analysing a single demand

curve as shown in Figure 2.1, quantity demanded varies inversely with price.
Aside from price, however, there are non-price determinants that can cause a change
in demand. These are:
1. Income
2. Population
3. Taste and preferences
4. Price expectations
5. Price of related goods
Individually and in combination, these factors can cause a shift in the demand curve,
either to the left or to the right.

Table 2.1
Individual’s Demand Schedule showing
the Inverse Relationship Between Prices and Quantities

Price Quantity
10 3
8 6
6 9
4 12
2 15

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Figure 2.1 Individuals showing the position of the demand curve indicates the inverse
relationship between demand and quantity demanded. This is graph of the demand
schedule in Table 2.1.

Non-price Determinants of Demand Explained

Income
Man buy greater goods and services when their income becomes higher. Less
fortunate people who become rich naturally purchase more basic goods, like food, clothing
and shelter; and services like luxuries, healthcare and good education. On the other hand
when their income becomes lesser, demand for such goods and services also diminishes.
Thus, the changes in income of man likewise change their demand for goods and services,
and either decrease or increase of demand is directly related to change in income.

Population
More people means greater demand for goods and services. There are more
consumers in the city community than in rural community. That is why we can observe
that there are more buyers in the city malls than in the barrio stores. The existence of
universities and colleges in the university belt has greatly affected the increase of demand
for goods and services in these areas. Conversely, few population means few demand for
goods and services.

Taste and Preference

Demand for goods and services is higher when people choose to desire or to choose
them. Such taste and preferences greatly influenced by TV and magazines or fashion trend.
On the other hand, if a product is out of fashion, the demand for it decreases.

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Price Expectations
When man expect the prices of commodities and services, especially inelastic goods
like rice, soap, cooking oil or sugar to increase in two days or next month, then buy more
of these goods. In the same way, consumers decrease their demand for these goods if they
expect prices to go down the next day or in a few days. The reason for such consumer’s
behavior is to at least temporarily insulate himself from the effects of change in price.

Prices of Related Goods

When the price of a consumer’s particular product go up, people tend to purchase a
substitute product. For example, if the price of Breeze increases, buyers buy less of Breeze
and more of the other of the other close substitute like Surf or Bio Cleene. This means that
the demand for Breeze goes down while the demand for substitute goes up. Conversely, if
the price of Breeze decreases, then the demand for it increases while the demand for the
other rivals decreases. However, in the case of complementary goods, the price of one
good and the demand for the other good is directly opposite. This means that if the price of
one good increases, the demand for the other good decreases. Complementary products are
those that go together like coffee and sugar. On components and CD’s, if the price of
component increases, the demand for CD’s decreases. Conversely, if the price of
component falls, the demand for CD’s rises. But for independent goods which are not
related, the change in price of one has little or no effect on the demand for the other. For
example: pens, goats and cards.

Law of Demand
The law of demand states that as the price of commodity decreases, all other things
being constant, the quantity of the product that buyers are willing and able to buy
increases. In short, there is an inverse relationship between price and quantity demanded.

Income and Substitution Effect

Income Effect
At lesser prices, a person has more purchasing power. This means he can buy more
goods and services. But at higher prices, naturally he can buy less. For example. The price
of bottle of Lipovitan before was P8.00. So P80.00 can buy 10 bottles. This shows that the
same amount of money or income can buy more goods when prices are lower than when
the prices are higher. An increase in price results to an effective reduction in his real
income.

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Substitution Effect
Consumers desire to buy goods with lower prices. In case the price of a product that
they are buying increases, they look for a substitute with a lower prices.

Changes in Demand
And Changes in Quantity Demanded
Changes in refers to the changes in the determinants of demand like income,
population, price expectation, and so forth.

The demand for a particular product is the relationship between price and quantity
demanded during a given time interval holding all other determinants constant. If the non-
price determinants of demand are allowed to vary, the location of the demand curve will
shift to the right or to the left. The most common observation is that, the change in the entire
schedule higher than the original demand schedule causes the demand curve to shift to the
right, while a change in the entire demand schedule lower than the original will causes the
demand curve to shift to the left.

Figure 2.2. Changes in the demand showing the shifting of the demand
curve to the right and to the left to indicate an increase or decrease in
demand respectively.

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 Movement Along the Demand Curve – change in quantity demanded brought
about change in price.

Figure 2.3. Increasing demand trend or Figure 2.4. Decreasing demand trend on
hypothetical graph that shows increase in quantity hypothetical graph that shows decrease in quantity
demanded. demanded.

Shift of the Demand Curve – change that takes place in a demand curve
corresponding to a new relationship between quantity demanded and price of that good. The
shift is brought about by a change in the original condition.

Figure 2.5. Demand curve shift to the right which Figure 2.6. Demand curve shift to the left which
means that there is a change in the entire demand means that there is a change in the entire demand
schedule higher than the original schedule. schedule lesser that the original schedule.

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Supply
Just like in demand analysis, price is also the primary determinant of supply.

Supply is the schedule of various quantities of commodities which producers are

willing and able to produce and offer at a given price, place and time. Supply may be
defined as a schedule which shows the various amounts of a product which are producers
are willing and able to produce and make available for sale in the market at each specific
price in a set of various prices during one specified time period. Supply simply shows the
amount of products producers will offer at various possible prices. Goods are considered
supply only if it is made available for sale.

Note that supply moves in the same direction price increases, supply increases, and
vice versa.

Table 2.2
Individual Supply Showing the Direct Relationship
Between Price and Quantity

Price Quantity Supplied

10 5
8 4
6 3
4 2
2 1

Figure 2.7. Individual supply showing a positively

sloping to the right curve. Supply schedule shows
the quantities that are available for sale at various
prices.

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Non-Price Determinants of Supply Explained
Technology
This refers to the techniques or methods of transforming raw materials into
intermediate or finished goods. Better technology promotes efficiency.

Cost of Production
In producing goods or products, raw materials are a necessity, together with the
laborers. If the price of raw materials or the wages of the laborers or the working force
increases, it means higher cost of production. There are other factors that affectcost of
production, e.g., interest, taxes and rent. If these increase, they result in higher cost of
production.

Number of Sellers or Producers

More sellers or producers means an increase in supply. Conversely, lesser number of
sellers or producers means less supply. This situation is very evident in advance or
industrialized states and countries.

Prices of Other Goods

Change in price of some goods have the reaction on the supply of other goods. For
example, the demand for copra in the world market is very low because of the existence of
substitute commodities that have lower prices than copra.

Price Expectations
If sellers expect prices to go up very soon, they usually keep their goods and release
them in the market when the prices are already high so as to give them windfall earnings.

Taxes and Subsidies

Certain taxes increase cost of production; higher taxes disappoint producers because
it reduces earnings. Subsidies, on the other hand, lower cost of production which helps
producers and suppliers.

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Law of Supply
As price increases, quantity supplied also increases; and as price decreases, quantity
supplied also decreases. This direct relationship between price and quantity supplied is the
law of supply.

Figure 2.8. Changes in supply showing the shifting of the supply curve
to the right if there is an increase or a change in the entire supply
schedule higher than the original. A shift to the left when there is a
change or there is a decrease in the entire schedule lower than the
original. The non-price determinants of supply are the responsible for
the shift.

The firm’s decision to maximize profit is influenced by the quantity of output or

product, so supply is dependent on:

1. The price of a good or service

2. The cost of producing the goods, which in turn depends on
a. The price of required input which is labor, capital and land
b. Technologies that can be used to produce the product
3. The prices of related products.

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 Movement Along the Supply Curve – change in the quantity supplied brought about
the change in price.

Figure 2.9. Increasing supply trend or hypothetical Figure 2.10. Decreasing supply trend or
graph that shows increase in quantity supplied. hypothetical graph that shows decrease in quantity
supplied.

Shift of the Supply Curve – change that takes place in a supply curve
corresponding to a new relationship between quantity supplied of a good and price of that
good. The shift is brought about by a change in the original condition.

Figure 2.11. Supply curve shift to the right which Figure 2.12. Supply curve shift to the left which
means that there is a change in the entire supply means that there is a change in the entire supply
schedule higher than the original. schedule lower than the original.

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The Law of the Demand and Supply
and the Market Equilibrium
In the market, demand and supply interact freely. Supply is represented by producers
or sellers, while demand is represented by buyers or consumers. Producers are willing and
able to offer goods at higher prices. This is the law of supply. On the other hand, buyers or
consumers are willing and able to buy at lower prices. This is the law of demand. There is
therefore a conflict of the two parties. One favors high price while the other favors low
price.

Table 2.3
Schedule of Supply and Demand
Indicating Equilibrium Price or Market Price

Price Quantity Demanded Quantity Supplied

10 2 10 surplus
8 4 8
6 6 6 equilibrium
4 8 4
2 10 2 shortage

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Figure 2.13. Equilibrium price established
between Demand and Supply.

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Market Demand
Defined as the sum of all quantities of a good or service demanded in a given period
of time by all the consumers purchasing that good or service in the market.

Deriving Market Demand from Individual Demand Curves

Figure 2.14. Household X’s Demand

Figure 2.15. Household Y’s Demand

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Figure 2.16. Household Z’s Demand

Figure 2.17. Market Demand Curve

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Market Supply
Defined as the total of all that is supplied in a given period of time by all producers
of a single good.

Deriving Market Supply from Individual Firm Supply Curves

Figure 2.18. Firm M’s Supply Figure 2.19. Firm N’s Supply

Figure 2.20. Firm O’s Supply Figure 2.21. Market Supply Curve

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Chapter 3
Responsibility
And Elasticity

According to Feliciano Fajardo, buyers and consumers are willing to buy greater and
tangible and intangible goods and lesser prices than higher prices . These are inherent
reactions or inclinations of consumers. However, such response changes depending on the
order of importance and availability of goods and services. This changing reactions and
responses are known as Demand Elasticity.
In the case of producers or sellers, they also have their responses and reactions to price
changes. Clearly, they tend to let go of more goods and services when price are higher.
Their responses also change depending on their availability to produce in a given time. For
instance, they cannot take advantage of higher pricesif they cannot produce the goods and
services. Such changing reactions of producers are known as Supply Elasticity.

Elasticity of Demand
Demand elasticity refers to the reaction or response of the consumers to alterations
in price of goods and services. As said earlier, costumers tend to decrease their purchases as
price increases, and tend to increase their purchases whenever price decreases. These are
logical reactions to price changes. However, such responses changes in accordance to the
nature of the products and certain needs of the buyers. For example, if a product is very vital
to the consumers, they have to have it despite the remarkable increases in its price. On the
other hand, there are goods in which a slight increase in their prices make many consumers
hesitant to buy such products. These goods are not important to them. They can still live
without the said products.

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Principles Behind Consumer Choice

1. There is always a limited income, while unlimited desires necessitate choices.

2. Consumers make good choices to achieve their purposes.
3. Consumers can substitute between “like” goods and services.
4. Consumers make decisions based on imperfect information.
5. Law of Diminishing Utility: As additional units of goods consumed increase utility,
adding another unit and additional more units would mean that utility will eventually
decline.

How Do Consumers Behave In Making a Choice?

Consumers will tend to adjust consumption for a good or service until the marginal
utility of consuming the good just equals the price of the good and service.

Consumer Demand Curve

1. Diminishing Marginal Utility implies that as the price of the good rises,the amount
demanded by the consumer will most likely go down.
2. Income and Substitution Effect is associated with change in price.

Relationships among Total Revenue,

Total Expenditures, and Price Elasticity of Demand

%Δ Expenditures @ %Δ Price + %Δ Quantity

1. Inelastic Demand. When elasticity of demand is less than one in absolute value, a
10% fall in price increases quantity demanded by less than 10%. Thus, the total
expenditure by consumers and the total revenue received by firms fall.
2. Elastic Demand. When elasticity of demand is greater than one in absolute value, a
10% fall in price increases quantity demanded by more than 10%. Thus the total
expenditure by consumers and the total revenue received by firms rise.

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 There are five (5) types of demand elasticity or five types of reaction of buyers to price
changes of goods and services.

1. Elastic Demand. A change in price results to a bigger change of quantity demanded.

For example, a 20% change in its price (increase or decrease) creates a 60% change in
quantity demanded (decrease or increase). This shows that consumers are very sensitive
to price change. They are easily discourage to buy the products if the prices increase.
Such products are not very important to them, but they give comfort and pleasure to the
consumers and buyers. These are the luxury goods like components, moving cameras,
VCD’s, etc.

2. Inelastic Demand. A change in price results to a lesser change in quantity demand. For
example, a 10 percent change in price only change in quantity demanded. This means
that consumers are not sensitive to price change. They cannot live without such goods
like rice, medicine or shelter. People have to buy said goods even if there is a
remarkable increase in their prices. However, a remarkable decrease in the prices of the
said goods has a very slight increase in quantity demanded. For example, a big decline
in the prices of rice and medicine does not encourage people to eat more rice or take
more medicine. They only buy as much as the requirement of their normal
consumption. But if the price is very high and many people cannot afford such price,
they have no choice but to eat thrice a day, or mix rice with corn.

3. Unitary Elastic Demand. A change in price results to an equal change in quantity

demanded. For example, a 50 percent change in price produces a 50 percent change in
quantity demanded. Goods or services under this criterion are considered semi-
important goods. Some types of clothings or shoes are either luxury or essential goods.

4. Perfectly Elastic Demand. In the absence of change in price, there is an infinite change
in quantity demanded. Such demand applies to a company which sells in a purely
competitive market.

5. Perfectly Inelastic Demand. An infinite change in price creates no change in quantity

demanded. This is an extreme situation which involves life or death to a person.
Regardless of price, he has to buy the product like a medicine with no substitute.

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Types of Demand Elasticity Showing the Various Degrees of
Reactions of Buyers Brought About By Price Change

Determinants of Demand Elasticity

1. Number of Substitute Goods. Demand is elastic for a product with many good
substitutes. An increase in the price of such product induces buyers to look for good
substitutes. On the other hand, products without good substitute have inelastic demand.
Buyers have no or little choice except to purchase them if they really need them.
Example, electric current for industry.
2. Price Increase in Proportionate to Income. If the price increase has very slight effect
on the income or budget of the consumers, demand in inelastic. For example, a 20
percent increase in the price of a pen or a chocolate bar means only a few centavos.
Thus, the result is only a slight decrease in quantity demanded. But if the price increase
involves a remarkable amount in proportion to the income of consumers, then

24
 the demand is elastic. For example, 30 percent increase in tuition fees is likely to
discourage many very poor families from sending their children to universities.

3. Importance of the product to the Buyers. Luxury goods are not very important to
many people. Examples are diamond earrings, BMW, sports cars, collectors item,
elegant wardrobes, etc. These are elastic. On the other hand, essential goods are very
important to people. Rice is very important to all consumers. Electric power is
important to factory owners. Gasoline is important to the transportation industry. All of
these are inelastic.

Price Elasticity of Demand

Economists have devised a formula to measure such responsiveness of consumers

demand to price changes.

This is known as the price elasticity of demand. The price elasticity of demand is the
ratio of the percentage change in quantity of a given good demanded to the percentage
change in its price.

The Determinants of Price and Income Elasticity of Demand

Price Elasticity of Demand=

Where

1. Is always negative.
2. Increase in price ΔP > will always reduce the quantity demanded ΔQd < 0.
3. Shows the degree of consumers responsive to variations in the price of good.
4. Price elasticity is affected by:
a. Availability of Substitute- more substitute mean more elastic demand.
b. Share the Total Budget Spent on Good- smaller means less elastic demands.
c. Length of Time Period- The longer the time the period, the more elastic demand.

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The formula for Price Elasticity of Demand is written as follows:

Or

Where:
ΔQ = Change in quantity demanded.
Q = Original quantity demanded.
ΔP = Change in price
Po = Original price.

Assume that the old price (or the price prior to change) is P22 with the quantity
demanded being 6 units. Now, if the price is to be lowered to P20 a unit, the quantity
demanded would become 10 units. The price elasticity of demand for this change can be
computed by the above formula.

Therefore, if given values are transformed on a table form, it would be a simple

Demand and Price relationship.

P Q
22 6
20 10

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Value of E: Kinds of E:

1. =0 1. Perfectly Inelastic
2. 0 > but < 1 2. Relatively Inelastic
3. =1 3. Unit Elastic
4. > 1 but < 10 4. Relatively Elastic
5. Infinite α ∞ 5. Perfectly Elastic

Economic Significance of Demand Elasticity

The concept of elasticity of demand is not just a theoretical exercise which has no
practical applications in business and economic policies. On the contrary, it has several
implications in both private business and government planning. For instance, a good
knowledge of demand elasticity helps the businessmen in planning their pricing strategies.
In the case of the government, elasticity guides the economic manager in formulating
appropriate tax programs. Clearly, the market price of a product influences wages, rents,
interests and profits with the right pricing strategies. Businessmen may attain the following
goals:

a. Achieve target return of investment;

b. Maintain or improve a share in the market;
c. Meet or prevent competition and;
d. Maximize profits.

Here are some practical examples of economic significance of elasticity of demand:

1. Wage Determination. If the product has an elastic demand, reduction in its price
increases quantity demanded. This means more sales and more profits. The company is
in position to raise the wages of its workers. But if the demand is Inelastic, a reduction
in its price has very little effect in sales. Such price cut may even affect the viability of
the company.

2. Farm Production Guide. Most agricultural products like rice, coconut and sugar are
inelastic. The quantity demanded does not change much even if there is a big decrease
or increase in price. Whenever there is an over production of farm crops due to good
harvest, prices of the said products decrease. As a result, the total revenue or income of
the farmers also declines. Measures are therefore prepared to control production to
protect the interest of the farmers. For example, areas of cultivation are being produced.
In some cases like Denmark, the surplus products are burned or dumped into the sea,
just to maintain price stability.

27
3. Maximize profits. A reduction in prices causes more quantity demanded. Businessmen
can estimate how far they can cut their prices to generate their target sales. Even if the
profit per unit is only 5 centavos. But millions of it are bought daily, the company is in
a better position to attain profit maximization than other products which gets a profit of
P5 per unit but only hundreds are bought daily. Evidently, a substantial price reduction
favors goods with highly elastic demands.

4. Imposition of Sales Taxes. Government planners should exercise prudence in taxing

goods and services. Otherwise, instead of getting more money from the people, they
will get less. It is not advisable to increase taxes on goods on high elastic demand. A tax
is an additional price. So, this greatly decreases quantity demand for the product. For
example, a P1.OO tax is imposed on a certain product, and P1,000 units are sold. Tax
revenue is P1,000. Supposing the tax has been increased to P2.OO. Because the
increase in tax, the price of the product will also increase. The result is that only 400
units have been sold. Therefore, tax revenue is only P800 which is P200 lower than the
original revenue.

Elasticity of Supply
Supply elasticity refers to the reaction or response of the sellers /producers are
willing and able to offer more goods at a higher price, and less goods at a lower price.
However, such responses of producers vary in accordance with the kind of goods they
produce. For example, there are goods which are impossible to produce in a short order
time to take advantage of increasing prices. These are the farm products which cannot be
increased in one-month time. In fact, some crops take several years to bear fruits like
coconut. In case of industrial goods, it usually takes a shorter time period to increase their
supply. Factories can respond to price increases by the overtime schedule of their workers.

Like demand elasticity, there are also five (5) types of elasticity of supply or types of
responses of producers to price changes:

1. Elastic Supply. A change in price results to a greater change in quantity supplied. This
means producers are very responsive to price change. For example, with 10 percent
increase in price, they increase their quantity supplied by 20%. Such reactions similarly
applies if there is a decrease in price. That is, the decrease in quantity supplied is even
bigger. Example are those goods which can be produced immediately or in a short time
like those produced by manufacturing firms like soft drinks.

28
2. Inelastic Supply. A change in price results to a lesser change in quantity supplied. This
shows that producers have weak response to price change. With a high price, they like
to increase their quantity supplied, but cannot do it at once. For example, if the price of
coconut increases, producers cannot respond immediately or in a short time. It takes 5
years or more to produce coconut. By that time, coconuts would be most likely
different.

3. Unitary Supply. A change in price results to an equal change in quantity supplied. For
instance, 15 percent change in price create 15 percent change in quantity supplied. This
is board line case between elastic and inelastic supply. Example of these goods are
those classified as semi-industrial or semi-agricultural products.

4. Perfectly Elastic Supply. Without change in price, there is an infinite m (without limit)
change in quantity supplied. Example, in a poor country with massive unemployment
prevails, an unlimited number of jobless individual are willing to work at a fixed wage,
even if the wage is very low, the general situation is in the rural areas of the less-
developed countries. In fact, in the cities, unemployed persons are willing to accept jobs
below their qualification and a low salary. Many department stores and big restaurants
do not give minimum wage to their employees. This is not fair, but jobless people have
little or no choice.

5. Perfectly Inelastic Supply. The change in price has no effect on quantity supplied. An
example of this is a land in a community. Land areas is fixed regardless of price. The
big increase in population has tremendously increased the price of land. There are
products which cannot be increased immediately or in a short-run period for lack of
machinery. Raw materials, or money (like dollars) are used for importing raw materials
or machines.

Types of Supply Elasticity Showing the Various Degrees or

Reactions of Sellers/Producers Brought About By Price Change
Figure 3.6 Elastic Supply

Figure 3.7 Inelastic Supply

29
 Figure 3.8 Unitary Supply

Figure 3.9. Perfectly Elastic Supply

Figure 3.10. Perfectly Inelastic Supply

Determinant of Supply Elasticity

The principal determinant of supply elasticity is the time involved in the ability of
products to respond to price changes. If it takes a short time to produce to take an advantage
of an increase in price, then supply is elastic. Factory products are generally elastic. If a
factory has sufficient available raw materials, it can increase in output by hiring more
workers and let them work overtime. However if such factory is already under full plant
capacity, it can no longer term response to price change (increase). In the long run, the
factory has set up more buildings and machines, and hire more workers of price is still
favorable.

On the other hand, if it takes a long time to produce the product, then supply is
elastic. Agricultural or farm products are usually highly inelastic. It takes months or years to
produce vegetables, fruits and crops. Clearly, this is one of the disadvantages of agricultural
or farming. Products cannot immediately response to a price increase.

With respect to formula in measuring the degree of elasticity of supply, the one
which is used in demand elasticity is also applicable. Just change the quantity demandedinto
quantity supplied.

30
REASONS FOR THE INCREASE OF THE PRICE ELASTICITY OF DEMAND
Second Law of demand says that the buyers will response greater after they have had
time to adjust more fully to a price change. Why?

Because they are better able to rearrange

consumption patterns to take advantage of
substitutes.

The Impact of Time on the Elasticity of Supply

1. Elasticity of supply usually increase in the long run as more time is allowed to the firms
to adjust production in response to price changes.

2. Over time, firms can adjust the levels of all factors of production in optimal ways to
meet changes in price.

Midpoint Formula of Price Elasticity

It is a precise calculation of percentages using the value halfway between P1 and P2
as the basis calculating percentage change in price and the midpoint values between Q1 and
Q2, as the basis of calculating the percentage change in quantity demanded.

Example:

Wherein:

% ∆Qd means % change in quantity demanded

∆Qd means change in quantity demanded

Wherein:
% ∆P means % change in price
∆P means change in price

31
Assuming that:
Q1 is 2pcs. Of green mangoes
P1 is P15.00 price level
Q2 is 4pcs. Of green mangoes
P2 is P10.00 price level

Therefore:

Price Elasticity of Demand is Elastic

32
Income Elasticity of Demand

This is the measure of the responsiveness of demand to changes in income.

How to measure?

Or

Wherein:

Assuming that:
Q1 = 12 pcs.
Q2 = 15 pcs
y1 = P4,000
y2 = P6,000

Therefore:

33
34
 Value of ey Kinds of ey
- inferior
1, > 1 Luxury
+
< 1 but > 0 Necessity

CROSS ELASTICITY OF DEMAND

This is a measure of the responsiveness of the quantity of one good demanded to a
change in the price of another good.

Or

Wherein:

Assuming that:
Qy1 = 2

Qy2 = 4

Py1 = 3
Py2 = 6

Therefore:

35
 = 1 substitute

Value of e x y Kinds of e x y
+ Substitute goods
- Complementary goods

Please take note that a different application of formula denotes different meanings
for values derived.

Chapter 4
Theory of Consumer Behavior
Marginal Utility Approach
Utility
1. It is the satisfaction derived from consuming specific quantities of a good.

2. It is the property or capacity of goods that satisfy the needs and desires of a person.

This approach makes use of the concept of marginal utility (or additional satisfaction) in
explaining the behavior of consumers demand. Briefly stated, marginal utility pertains to the
additional satisfaction derived from (a small) additional unit of a good consumed or
acquired per unit of time. This definition implies that utility or satisfaction can be measured
like, say, the height or weight of a person, although the analysis requires only that the
satisfaction obtained or acquired from successive units of a given commodity and from
various commodities can be ranked and compared.

36
 Table 4.1
Utility Schedule

Quantity Total Utility Marginal Utility

1 14 -
2 26 12
3 36 10
4 44 8
5 50 6
6 54 4
7 56 2
8 56 0
9 54 -2
10 50 -4
11 44 -6
12 36 -8
13 26 -10
14 14 -12
15 0 -14

The functional relationship assumes two (2) forms and is quantitatively defined as follows:

TU = f(Q)

MU =

Wherein:

TU = Total Utility

f = is a function of

MU = Marginal Utility

Q = units of consumption

Δ = infinitesimal change

37
 Table 4.1. The Trend of TU and MU

Law of Diminishing Marginal Utility

In conclusion based on Table 4.1, the diminishing marginal utility (MU) causes the total
utility (TU) to decline eventually, for which reason maximum consumption is only up to the
point of maximum utility.

Indifference Curve Approach

And the Budget Line

Indifference is the locus of Good y and Good x that yield the same amount of
satisfaction. A curve shows a set of combinations of quantities of two things or good such
that an individual is indifferent between any combinations in the set. Thus, suppose the two
things in question were consumption of goods, say avocados and bananas. It would now be
a question of how many avocados and how many bananas one could possibly have with a
given budget that will give the greatest satisfaction of optimum combination possibilities on
a graph as follows:

38
Figure 4.2. An in difference curve graph that shows variouscombination or mix that yield the same level of
satisfaction

The characteristics of consumer indifference curves

1. More goods are preferable to fewer goods; thus, points to upper right preferred to points
in lower left of utility curve diagram.

2. Goods are substitutable; hence, utility curves slope downward to the right.

3. Diminishing marginal rate of substitution between goods implies utility curves always
convex to origin.

4. Indifference curves are everywhere dense, i.e. one through every point.

5. Indifference curves cannot cross because if they did, then individuals would not be
following a rational ordering.

The Role of the Consumption Opportunity Constraint and the Budget

Constraint in Indifference Analysis

1. Consumption Opportunity Constraint. This separates consumption bundles that are

attainable from those that are unattainable.

In money-income economy, income

is usually same as budget.

2. Budget Constraint. Separates consumption bundles that consumer can purchase from
those that cannot be purchased, given the consumer’s limited income and the market
prices of the products involved.

39
3. Consumer’s Choice. Determined by the point in which their highest indifference curve
touches the budget (or consumption opportunity) constraint.

This point yields highest level of

utility for a given level of income or
market prices.

Each point on the curve represents a particular combination of bananas and avocados
and it will still yield the same amount of satisfaction. As we can qualify satisfaction through
utils which is the unit measurement of utility. Let us characterize the indifference curve
which represents the level of satisfaction.

1. It is downward sloping. This simply expresses the idea that if we subtract some
quantity of one of the goods from the others to compensate and so, leave him with a
new bundle equivalent to the first.
2. It is convex from the point of origin. It bulges outward when looked at from below.
This particular curvature of the indifference curve simply gives expression to the
idea that one good becomes more relative to the others; its subjective worth becomes
smaller in terms of the others.
3. Higher indifference curves yields higher satisfaction while lower indifference curve
yields lower satisfaction.

Figure 4.3. Indifference contour map

40
 We can therefore regard that higher indifference curve gives higher satisfaction.

Face by a problem of say: What is the optimum combination of Good X and Good Y
that yields the same amount of satisfaction with the following:

Given:

1. Price of Good Y = P2
2. Price of Good X = P1
3. MU schedule of Y =
4. MU schedule of X =
5. Budget = P14

MU Schedule of Y MU Schedule of X
Quantity MU Muy/Py Quantity MU MUx/Px
1 100 utils 1 100 utils 100
2 95 2 80
3 90 3 60
4 85 4 40 40
5 80 40 5 20

There are six steps to follow in the proper computation of the optimum combination:

1. State the necessary condition.

2. Work out the first element in the equation
3. Work out the second element in the equation.
4. Find the equimarginal value.
5. Choose the quantity combination.
6. Proof: TC = Budget

1. Necessary combination can be expressed by:

41
2. In reference to the first equation:

Let MUy/Py be computed as:

3. In reference to the second equation:

Where:

4. To find the equimarginal value, let us first define the term. It is a value derived out
of the necessary condition that Good Y and Good X yields and coincide on this
level. Therefore, E.M.V. = 40
5. To continue with the next steps, note that E.M.V. = 40 and quantity of Good Y in
this level is 5 while quantity of Good X in this level is 4. Therefore, quantity
combination is:

5 for Good Y

4 for Good X

42
6. Prove that TC = B, we can now properly justify if our combination coincides with
the given budget which is P14.oo

5 Y x P2 = 10

4 X x P1 = 4 / 14

43
 Let us now have a graph that shows the relationship of Good Y and Good X based
on the above data.

Figure 4.4. A graph that describes the point of tangency

Where satisfaction (IC = 40 utills coincide with the budget (14).

Figure 4.5. Income and Substitution effects

1. At original prices, consumer chooses point A.

2. Price of Good x falls, budget line rotates out.
3. Consumer move to point C. Can break move into two parts.
4. Income effect is moved from A to B. Prices same, but reaches higher utility assoc. with C.
5. Substitution effect is moved from B to C. Prices change, but stay on same utility curve.

44
 Chapter 5
Production

The branch of economics concerned with analyzing the determinants of the firm’s
choice of quantities inputs, given its production function, the prices of inputs and the level
of output it wishes to produce. The theory is based on the hypothesis that the firm will wish
to use of quantities of the input which minimizes the overall cost of producing a given
output. Then by varying output, it is possible to construct input-output relationships, which
are the bases for much of the theory of the firm. In addition, the analysis in production
theory forms the basis for the theory of marginal productivity and the determination of
factor prices.

Goods produced by man are called economic goods. There is a cost in the production
of the economic goods. However, there are goods which are produced without costs. These
are goods produced by nature. Such goods are called free goods. Examples are fresh air,
sunshine, a pool of clear water in the mountain, edible fruits in the virgin forest, and so
forth. You may ask: what about those goods which are given free by the government or by
civic organization? Well, these are free in the sense that they are given free. But still. They
are economic goods. The government paid those goods with taxes – which are the money of
the people.

45
Theory of production
The theory of production is an analysis of relationship between output (goods and
services) and input (resources used in production).

The conditions of production underlie the theory of supply.

The short-run and the long-run

The short –run is a period of time during which at least one input is fixed while the
others are variable. Resources that can be varied in the short-run are called variable inputs
while those that cannot be changed are called fixed inputs.

The long-run is a period of time that is sufficiently long for all the inputs to be
varied, enabling supply to have great flexibility.

1. Short-Run in Production. Time period is short enough that not all factors of
production can be adjusted. Typically, plant size is fixed.
2. Long-Run in Production. Time period is long enough, so all factors of production
can be adjusted.

Factors of Production
The success of production depends on the effective organizations of the four factors
of production namely: land, labor, capital and entrepreneurship.

Land
In economics, land – sometimes called natural resources – includes not only the
surface of the globe but also what is under and above the surface. It embraces the natural
environment – the oceans, rivers, soil, climate, mineral deposit and all other gifts of the
nature.

It is the basis of all production, because from land comes all the wealth of man. The
raw materials utilized in the production come from land.

Labor
This is next to land in degree of importance as a factor of production. It is defined as
the exertion of human effort, physical and mental, to earn an income. Land without labor is
useless; exertion is necessary to make a living.

46
Capital
The third factor of production is that part of wealth, other than land and personal
services, which is used as an aid to further production. Capital includes machinery, tools and
raw materials. Money is called cash capital.

Three Requirements of Capital

1. It must be a product of past industry of man.

2. It must be wealth.
3. It must be used to produce more value.

Distinction Between: 1) Explicit Costs and Implicit Costs, 2) Economic Profit and
Accounting Profit, and 3) the Short-Run and the Long-Run Production

1. Explicit Costs. Payments by a firm to purchase productive resources.

2. Implicit Costs. Opportunity costs of a firm’s use of resources that it owns. These
costs do not involve direct payments.

3. Economic Profit. Difference between firm’s total revenue and total cost.

4. Accounting Profit. Firm revenue minus expenses over given time period. Does not
take implicit costs into account.

Entrepreneurship
An entrepreneur is often called the “captain” of the industry because he is the one
who initiates and organizes the business and puts them together in te right and optimum
proportion.

Theory of production
An organized body of knowledge that puts together the rationale for production
situation.

Production function
It is therefore important that combinations of inputs present in the functions of
production must be materially and technically efficient. A resource input combination is
said to be efficient is lesser quantity of any one or more of the inputs induces the reduction
of the number of output.

47
Law of Diminishing Returns
The law of diminishing return in productivity states that is some inputs are held
constant while others are allowed to vary, marginal productivity will decline at some point
as a result of adding more units of that inputs that were allowed to vary.

Table 5.1
Law of Diminishing Returns in Productivity
500 square meters of furniture factory
Labor Total Marginal Average
Input Product Product Product
2 4 0 2
4 8 2 2
6 16 4 2.66
8 28 6 3.5
10 44 8 4.4
12 64 10 5.33
14 80 8 5.71
e16 92 6 5.75
18 100 4 5.55
20 104 2 5.2
22 104 0 4.72
24 100 -2 4.16

Production in the short-run is influenced by the Law of Diminishing Returns. The

Law states that as successive units of variable resources (inputs), say labor, are added to
fixed resources, say land, beyond some point, the extra or marginal product attributable to
each unit of the variable resources, will decline.

1. Total Product (TP) is the total amount produced during some period of time by all
the factors or production employed over that time period.

2. Average Product (AP) is the total product per unit of variable input.

48
 3. Marginal Product (MP) is the change in the total product per unit change in quantity
of the variable input.

Marginal Product shows the change in total output associated with each additional
input of labor. Different levels reflect increasing returns. Beginning with the other level,
marginal product diminishes continuously and, actually becomes negative with the next
level of workers.

Stages in Diminishing Productivity

1. Increasing returns. TP increases; AP increases and reaches maximum; MP
increases and reaches maximum and decreases; MP is greater than AP, except
when AP is maximum; boundary of I and I is the intersection AP and MP; AP
intersects MP, at its maximum point.

2. Decreasing Increase in Return. AP begins to decline; TP increases and reaches

maximum; AP decreases and becomes zero; MP zero; TP maximum.

3. Negative Returns. TP decreases; AP decreases; MP negative.

Figure 5.1. The Cost Curve Relationship

49
Figure 5.2. Diminishing Return in Productivity Trend Based on Table 5.1 with Stages of Diminishing Return
in Productivity

The Law of Diminishing Returns and its Impact on a Firm’s Costs

Law of diminishing Returns to a factor of Production

As more and more units of a variable input are combined with a fixed amount
of another input, the additional of the variable input will yield increased output at a
decreasing rate.

50
 The shapes of the Short-Run Marginal Cost, Average Variable Cost, Average
Fixed Cost, And Average Total Cost:

1. Once you have reach a level of output where diminishing returns occur, larger
and larger additions of the variable factor are necessary to increase output by one
more unit.

2. Result is MC of the additional output increase. So long as MC is below ATC,

producing additional units of output will bring down the ATC curve.

3. At some point, however, MC will raise enough to exceed ATC.

4. After the point where MC = ATC, additional units of output will raise ATC
causing the ATC curve at its minimum point.

Production Isoquant
It is a varying combination or is mixed in the utilization of resource input
corresponding to the same level of output.

The points along the isoquant curve represent a different combination of capital and
labor input corresponding to a particular plat capacity. Between any points to another, an
inverse relationship exists between these resources as the output that production foregoes by
utilizing less of one regained by utilizing more of the other.

Table 5.2 relationship of Capital Input and Labor Input that Results to MRS
(Marginal Rate of Substitution)

LI KI MRS
1 30 -
2 26 4

3 22.5 3.5
4 19.5 3
5 17 2.5
6 15 2
7 13.5 1.5
8 12.5 1
9 12 .5
10 12 0
51
Figure 5.3. LI + MRS Relationships (production Isoquant Curve and MRS Curve)

The cost of Production

One of the determinants of supply is cost of production. Producers have
unquestionable pursuit to supply a product of lower cost for production. As mentioned
earlier, inputs or resources are needed in the production of goods. The prices of such inputs
are determined by demand and supply. Resources which are scarce, and there is a great
demand for them to command higher prices. This means higher cost of production that
result to a higher price of productions.

Cost has a relative effect both to producers and consumers. Since an upswing
disturbance in the increase of production cost consequently increases the price of products,
the tendency of buyers is to lessen their purchases. Such reaction of buyers is in reference
with the law of demand. For this reason, producers seem to be in continuous search of ways
and means to cost cutting scheme. Less cost means less price. Less price means more sales –
and more profits. Particularly speaking, the Philippines is far from being competitive in this
respect because of factors that are inherent with high costs.

52
 The presence of abundant resources makes it cheaper to produce. In less developed
countries, labor is abundant while capital (machines) is scarce and expensive. It is the
reverse in other western developed countries where labor is expensive and capital is cheap.
In the United States, it is cheaper to use robots than to hire workers. Only the very rich can
afford to employ household helper. In the Philippines, wages are sometimes below
subsistence level. Thus, even some of the corporate employees of a company are willing to
be a D.H. (domestic helper) of other countries.

Economic Costs
1. Total Cost. The sum total of cost of production. It is composed of wages, rents,
interests and normal profits. These are also known as factor payments: wage for
labor, rent for land, interest for capital, and normal profit for the entrepreneur.
Normal profits are therefore part of the total cost of production. It is the amount
which is sufficient to encourage an entrepreneur to remain in business. In the
case of pure profit, it is an amount which is in excess of cost of production. Total
cost is also equivalent to fixed cost plus variable cos.
2. Fixed Cost. A kind of cost which remains constant regardless of the volume of
production. Even if there is no production, there is still cost. Examples are the
expenditures on the machines and buildings. Whether you use these factors of
productions or not, you have to pay for them.
3. Variable Cost. A kind of cost which changes in production to volume of
production. If there is no production, there is no cost. More productions means
more costs. Examples are ages, raw materials and oil products.
4. Average Cost. This is also called unit cost. It is equivalent to total cost divided
by quantity.

5. Marginal Cost. The additional or extra cost caused by producing one additional
unit. It is obtained by dividing change in total cost by change in quantity.

53
 6. Explicit cots. This is also called expenditure cost. These are payments to the
owners of the factors of production like wage, interests, electric bills, and so
forth.

7. Implicit Cost. Another tern for this cost is non-expenditure cost. The factors of
production belong to the users, so they do not pay. You do not pay rent to your
land.

8. Opportunity Cost. This is the foregone opportunity or alternative benefit. For

example, the super powers are spending more than $1 trillion dollars a year for
arms race, sand such amount is more than enough to erase global poverty from
the face of the earth. So hunger and poverty still prevail around the world.

Figure 5.4. Hypothetical, Total, Fixed and Variable Costs

Production Cost Formulas:

54
Types of Production Responses
1. When slope of TP curve is the same to that of the next points

2. When slope of TP curve continues to increase but on a decreasing pattern

55
 3. When slope of TP curve reflects a continuous increase in an inter mitten pattern

Figure 5.7. Accelerated Increase

Economics and Diseconomies of Scale

Possibilities and the Relationship of Each to the Shape of a firm’s Long-Run
Average Total Cost Curve
1. Economies of scale. Reductions in firm’s per unit costs as all factors of
production are increased in an optimal way.

Possible Reasons:

a. Mass production

b. Specialization of factors of production

c. Learning by doing scale economies

2. Diseconomies of Scale. Increases in firm’s per unit costs as all factors of

production are increased in an optimal way.

Possible Reasons:

a. Coordination inefficiencies

b. Increasing difficulties in conveying information

c. Increased principal-agent problems

3. Constant Returns to Scale. No change in firm’s per unit costs as all factors of
production are increased in an optimal way.

56
Figure 5.8. Economies and diseconomies of Scale

Factors that cause cost curves to shift

1. Prices of resources. Increase in price of resources used (inputs to
production) will cause a firm’s cost to shift upward.

2. Taxes. Increased taxes shift up a firm’s cost curves. Tax on variable input
shifts MC, AVC, and ATC. Fixed tax shifts AFC and ATC.

3. Technology. Cot-reducing technological improvements will lower a firm’s

cost curves in which these curves depend on whether technology affects
fixed or variable costs.

The Basic Framework for Break-Even Analysis

The break-even analysis is the heart of the modern management accounting system.
It is used as the firm’s guide in making critical business decisions, such as how much to
produce (volume of production) and how much to sell the product (pricing).

The basic equation goes as follows:

Hence, to set the break-even volume:

57
And, to get the break-even price:

Example 1:

Given:

P = P10/unit

TFC = P350,000

TVC = P500,000

Find:

Qbe = ?

Solution:

Example 2:

Given:

TFC = P350,000

TVC = P600,000

Q =100,000

Solution:

58
59
 Chapter 6
Market classification and Structure
Pure Competition

Competition has always been a part of human motivation and activity. Competition
can make wonders in the company. The best in human activity, like the best record in the
100-meter dash in the Olympics can be brought out in a spirit of competition. The best shoes
can be produced in the market if there is a favorable competition among the shoe producers.
Fair competition can make wonders both in human activities and in the market system.
Needless to say, prevented and unbridled competition can lead to undesirable ends.
Pure competition is a market structure where there are a large number of
independent firms selling homogenous or identical products.

The following are the characteristics of Pure Competition:

1. There is a numerous number of independent sellers of a commodity, each too small

to hardly feel the difference in commodity price.

2. All firms in the industry sell one or the same products. As a result, the buyers cannot
distinguish between the products of one firm and that of another, and so they are not
different to the particular firm from which they buy. This refers not only to the
physical characteristics of the product but also to the environment such as the
location and pleasantness of the sellers, etc. in which the purchase is made.
Examples are agricultural products like vegetables, root crops, etch.

3. Each individual buyer or seller is a price dependent. That is, no firm can influence
the market price by deciding to increase or decrease its production and no buyer can
influence the market price by deciding to increase or decrease quantity purchased.

4. There is a freedom of entry and exit of firms in and out of the industry. There are no
barriers like legal, financial and technical requirements.

5. There is no competition to advertising, sales promotion, etc.

60
The Price Takers Versus price Searchers in the Competitive Process
Distinction between Price Takers and Price Searchers
1. Price Takers. Firms that take market price as given when selling their product. Each
is small relative to market, and cannot affect the price.

2. Price searchers. Firms that face a downward-sloping demand curve for their
product. Price charged by firm affects the amount it sells.

The Conditions that Characterize a purely Competitive Market

1. Markets characterized by a large number of small firms producing identical products
in industry with complete freedom or entry/exit

2. Also termed price price-taker markets

How and why Price Takers Maximize Profits at the Quantity for which Marginal
Cost = Price = Marginal Revenue:

1. Marginal Revenue of each unit of output sold = Market Price

2. Price-taking firm sets output, so Marginal Cost of last unit of output produced equals
market price = marginal revenue.

3. If MR > MC, hen selling an additional unit adds profit.

4. If MR< MC, then selling an additional unit lowers profit.

5. Maximum profit when MR = P = MC of last unit

61
The total revenue and the marginal revenue for a price taker
1. For a price taker, total revenue is simply equal to the price in the market times the
number of units of output sold.

2. Marginal revenue, the change in total revenue/change in output, is constant for a

price taker and equal to the market price of the product.

Decision by Price Takers with Economic Losses to Either Continue to

Operate, Shut Down, or Go Out of Business
1. A firm that is making losses, i.e. ATC > P, will choose to continue to operate in the
short-run so long as:

a. It can cover all its variables costs, i.e. P> AVC; and

b. It expects price t be high enough to cover its average cost in the future.

2. In the short run, the firm must pay its fixed cots even it shuts down. So long as price
exceeds the average cost, the firm will be able to pay part of its fixed costs.

3. This strategy makes sense as long as the firm expects that at some point, price will
rise sufficiently to cover both its variable and fixed costs, i.e. P= ACT.

62
63
Price and Output Determinants
The demand of an individual firm under a purely competitive industry is perfectly
elastic. This is because the decrease or increase in the output of a single seller has no effect
on the total supply and the market price. However, in the case of market demand curve
(demand curve of all producers of a particular product), it is inelastic. All producers acting
at same time can affect total supply and also the market price. They can sell more units of
their output at a lower price. This is the law of demand.

Table 6.1 illustrates the demand and revenue schedule of an individual firm in a
purely competitive industry. I is noted that the price of the product. The average revenue
and marginal revenue are the same. In figure 6.1, the marginal revenue curve is equal to the
demand curve of a purely competitive firm because it can sell any unit of output at a
constant market price. The total revenue curve is straight up the sloping line.

Table 6.1. Demand and Revenue Schedule

of a Purely Competitive Firm
Price Quantity TR MR AR
Demanded
P4 1 P4 P- P4
4 2 8 4 4
4 3 12 4 4
4 4 16 4 4
4 5 20 4 4

Figure 6.1 demand, marginal revenue and total revenue of a Purely competitive Firm

64
Graphical Analysis
Price and output determination in a purely competitive firm is shown and explained
through graphical illustrations. Such graphs indicate the most profitable output and least loss
output. The equilibrium of the firm (through the MR = MC approach) under the short-run
are also presented.

Figure6.2. Short-run equilibrium of a firm under pure competition which indicates 60 units at a price of P2 per
unit as the most profitable output. This is determined by the intersection of MR and MC curves where MR =
MC (or the equilibrium of the competitive firm which is also profit maximization). Note that the higher MR or
price is higher than the average cost. This means that the competitive firm is earning pure profit. Such profit
attracts more firms to enter the industry.

Figure 6.3. Loss minimization of a competitive firm a short-run is indicated by an average cost higher than
price or MR. this means that the firm is losing. To minimize loss, the firm should produce an output where
price == MC (or MR = MC)

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Figure 6.4. Long-run equilibrium position of a competitive firm where MR = MC = AC + price. During the
short-run period, an efficient firm and other firms in the industry do enjoy pure profits or economic profits.
This means that their revenue is higher than their market. This increases supply and decreases price. Thus,
through the process of competition, pure profit is ultimately eliminated. Only the normal profit remains
(revenue is equal to cost). The less efficient firms that could not even claim normal leave the market or
industry.

Short-Run Analysis
The short-run is a period of time long enough to allow adjustments in certain factors
so as to increase or decrease output, but short enough so as not to allow alterations in plant
capacity. In other words, during the short-run, the amount of some factors such as labor and
raw materials can be varied, but some other factors like the number of machines being used
are fixed.

During the short-run period, market price tends towards the short-run equilibrium
level. This means that the market price will move toward that level wherein demand is first
equal to supply after allowing short-run adjustments, i.e., after adjustments in output are
made by the sellers, given the capacity of their plants. Movements in price will be made if
the prevailing market price deviates from the short-run equilibrium level.

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Figure 6.5. Short-run Equilibrium Market for Price Taker

Short-run Supply Curve in a Competitive market

1. SR Supply for Individual Firm. Marginal cost above AVC.

2. SR Supply for market. Horizontal sum of all the marginal cost curves of firms in the
industry.

Long-Run Analysis
The long-run pertains to a period of time sufficiently long to allow a) all desires
adjustments in the quantities of all factors of production employed, and b) changes in the
number of firms in the industry. Since all desired adjustments can be done, fixed cost is non-
existent, and does not enter into the long-run analysis of the firm.

Contrast as to the Role Constant Cost, Increasing Cost, and Decreasing Cost Industries and
the Shape of long-Run Market Supply Curve

1. Long Run Supply Curve – shows minimum price that firms will supply any level
of market output, given sufficient time to adjust all factors of production and allow
for any entry/exit from the industry.

2. Economies of Scale – determine shape of LR supply

3. Constant Returns to Scale (i.e., Constant cost) – industry will have horizontal LR
supply curve.

4. Increasing Returns to Scale (i.e., declining cost) – industry will have downward-
sloping LR supply curve.

5. Decreasing Returns to Scale (i.e., increasing cost) – industry will have upward-
sloping LR supply Curve.

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The Impact of Time on the Elasticity of supply
1. Elasticity of supply usually increases in the long run as more time is allowed to firms
to adjust productions in response to changes n prices.

2. Over time, fir, firms can adjust the level of all factors of production in optimal ways
to meet changes in prices.

The price searchers in the Competitive Market

The Conditions that characterize
Competitive Price-Searcher Markets
1. Each firm faces a downward-sloping demand curve for their output.
2. Firms produce differentiated products. Output of other firms is close substitutes, so
individual firm’s demand curve is highly elastic.

3. Low entry barriers allow entry or exit of firms if existing firms earn non-zero
economic profits. Each firm faces competition from existing firms in industry and
potential new entrants.

How price searchers choose price and output combinations.

The profit-maximizing behavior for a price searcher is:
1. Sets output level so that Marginal Cost is equal to Marginal Revenue.
2. For Price Searcher, Marginal Revenue is related to the shape of the Demand Curve.
Intuition for two factors at work to sell additional unit of output.

Figure 6.6 Profit-maximizing Monopolist

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Figure 6.7 economies and Diseconomies of Scale

Summary of the Efficiency of Price- searcher Markets with Low Entry Barriers
including the Entrepreneurship, allocated Efficiency
1. (+) In the long run, competition along with free entry and exit will drive prices down
to level of average costs.

2. Contestable markets: market cost of entry or exit are low, so firms risk little by
entry.

3. Efficient production and zero economic profits should prevail.

4. Market can be contestable even if capital requirements for entry are high.

5. (-) LR equilibrium is not allocatively efficient because firms produce less than the
minimum ATC of output.

6. Advertising in differentiated product markets may be wasteful and self-defeating.

Benefits of dynamic competition improve customer choices of quality

and convenience versus trade–off of higher prices.

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Price Discrimination Increases Output and Reduces Allocation
inefficiency
1. Price discrimination occurs when a producer charges different consumers different
prices for the same product.

a. Requires supplier to identify and separate at least two groups with different price
elasticities, and

b. Prevents those buying at low price form reselling to higher priced customers.

2. Segmentation of groups with differently price elasticities allows suppliers to change

different prices to each, possibly resulting in higher profits than with a single price
alone.

3. On balanced output in industry higher with price discrimination than without. Moves
industry output closer to competitive output level associated with allocation
efficiency.

Competition is an important Disciplinary Force in a market where barriers to

entry are low

Competition places Competition Competition causes

pressure on provides firms with firms to discover the
producers to strong incentive to type of business
operate efficiently develop improved structure and size
and cater to products and that best keeps per
preferences of discover lower-cost unit costs of
customers production production low.
methods.

Aspects of Pure Competition

Subject to certain limitations, most economists agree that a purely competitive
economy will lead to the most efficient allocation of resources. A competitive economy will
tend to allocate the fixed supplies of resources available to society to maximize consumer
satisfaction.

First, because of the presence of competition, firms would be forced to produce

those goods which consumers want most. In additional, price changes by firms under
competition would be reasonable to both producers and consumers.

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 Second, the presence of competitive forces in firms will use the most efficient, or
least-cost methods in the production of these goods. Firms under pure competition cannot
afford to produce goods of inferior quality. Consumers will shift to producers, who will
produce better quality goods or services assuming the presence the presence of competitive
pricing. These two important conclusions can be explained by going back to some principle.

1. The first principle implies the effect of P = MC. This principle implies that
production must not only be technically efficient, but it must also entail the
production of the right goods consumers need and want the competitive price
system sees to it that resources are allocated so that they best fit preferences of
consumers.

To summarize, under pure competition, producers will produce each

commodity up that precise point which price and marginal cost are equal.
Resources are efficiently allocated, given their situation.

2. The second principle implies the working of P = AC principle. We discussed that

in the long run, the presence of competition forces firms to produces at point of
minimum average cost of production and to charge prices with these costs.

The principle also means the consumers benefit from the highest volume of
production and the lowest price which are possible under a competitive market. It also
implies that the costs involved in each instance are only those costs essential in the
production of a product. This would mean the lowest possible price would only get normal
profits for their ventures.

A final appealing feature of a purely competitive economy is that the highly efficient
allocation of resources which it fosters comes about because business and resources and
suppliers freely seek to further their own self-interests. This means that the invisible hand
theory is at work in a competitive market system. In a competitive economy, businesses
employ resources until the extra or marginal cost of production equal the price of the
product. This does not only maximize the profits of the individual producers but
simultaneously results in a pattern of resource allocation which maximizes the satisfaction
of consumers. The competitive system organizes the private interests of producers along
lines which are fully in accord with the interests of society as a whole.

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Pure monopoly
Pure monopoly exists when a single firm is the sole producer of a product or a
service for which there are no close substitutes. When we talk of close substitutes, we mean
there are no other firms producing the same product or products varying only in the minor
ways from that of the monopolist.

Monopoly is virtually nonexistent in basic manufacturing industries but was fairly

common in steel, aluminum, tobacco and other areas. The tobacco industry and steel
industry are cases that can be cited. Cited now, it occurs most commonly in regulated public
utilities and in particular geographical areas where transport costs allow a local seller to act
as a monopolist within a certain range of prices.

Pure monopoly refers to the form market organization in which there is a single firm
producing a commodity or a service for which there are no close substitutes. Thus, the firm
is the industry and faces a negatively sloped industry demand curve for the commodity or
service.

Characteristics of price of pure monopoly

1. There is only one firm selling the commodity. A monopolist is a one-firm
industry. The firm and industry are the same.

2. There are no close substitutes for the commodity. This means that there are no
reasonable alternatives. The buyers must buy the product from the monopolist or do
without it.

3. The monopolist decides on the price. This means that the monopolist exercise
considerable control over the price.

4. Entry to the industry is very difficult or impossible. There are barriers or certain
obstacles that exist to keep new firms away from the market.

5. There may be or no non-price competition like advertising, sales promotion, etc.

non-price competition may be used only for public relations because the consumers
already know from whom they must purchase the product.

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Price and Output Determination
There is only one firm that produces the product. The demand for the product of the
firm is the same as the market demand for the product. Since there is only one firm, it is also
the industry. Its demand curve is the industry demand curve which is downward sloping.
This means a monopolist can only increase his sales by offering a lower unit price for its
product. If he does this, his marginal revenue (additional income) is lesser than the price.

Table 6.2 shows the demand and revenue schedule of a pure monopolist. It is noted
that more units are sold at a lower price. However, total revenue increases at a decreasing
rate and then declines after reaching its maximum. In the case of marginal revenue, it is
always lower than the price. Naturally, at a lower price of an additional unit sold, the
additional income is lower than the previous additional income. Please refer to table 6.2.

Table 6.2 Demand and Revenue Schedule

of a pure Monopolist

QD Price TR MR
1 P40 P40 -
2 35 70 30
3 30 90 20
4 25 100 10
5 20 100 10
6 15 90 -10
7 10 70 -20

Figure 6.8. Demand, Marginal Revenue and total Revenue, and Imperfect Type of Market Structure Like the
Monopolist.

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Graphical Analysis
Price and output determination under pure monopoly is shown and explained
through graphical illustrations. The graphs indicate the profit-maximizing and loss-
maximizing positions of a pure monopolist. The first graph shows that the pure monopolist
enjoys a monopoly profit. The monopolist continues to enjoy such profit because there are
no competitors. Unlike pure competition, the existence of pure profits attracts the entry of
more new firms. This results to lesser profits until the point where only the normal profits
remain. However, despite the advantages of a monopolist, he does not change the highest
price because this will decrease his sales and consequently his total profit.

Figure 6.9. Profit Maximization Under the Pure Monopoly (Price > AC)

Figure 6.10 Loss Minimization Under Pure Monopoly (Price < AC)

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The Welfare Effects of Pure Monopoly
We can now compare two markets: a market characterized by pure competition and
one characterized by pure monopoly. Obviously, from the point of view of producers, a
monopolistic market would be proffered. A monopolist does not have to contend with any
competitor, has considerable control over price decisions, and has therefore more chances of
maximizing profit. Given these factors, what welfare considerations are in store for the
consumers? The following discussions will answer this question.

Short-Run Output Restriction

In all industries were initially purely competitive and were in a long-run equilibrium,
monopolization of one or more of them would reduce consumer welfare. This statement will
be further clarified by the following graph as illustrated in Figure 6.11.

Figure 6.11.

As we have seen in our previous discussion on pure competition, equilibrium price is

reached when price equals the cost of production or the lowest point of the average cost
curve. In our graph, price and output under pure competition would be placed at P2 and Q2.

In contrast, a monopolist would maximize at the point where the marginal revenue
just equal marginal cost. As seen from the graph, the monopolist sees the market demand
curve sloping downward to the right and marginal revenue curve that lies below the demand
curve like MR in our graph. To maximize profit, the monopolist would produce an output Q,
and would peg his price at P1,

As we can see further, the price change by a monopolist would be higher compared
with that charged in a market characterized by pure competition. In addition, the amount of
goods available to the consumers would be less (Q 1) compared with more goods (Q2) that
would have been available to the consumer if the market were characterized by pure
competition.

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Inefficiency of the Firm
In addition to the welfare impact of output restriction, the monopolistic firm
ordinarily will not use resources at their peak potential efficiency. The purely competitive
firm in long-run equilibrium uses the most efficient size of p [lat at the most efficient rate of
output. The size of plant and the output that maximizes the monopolist’s long run profits are
not necessarily the most efficient ones. However, if monopoly is to be compared with pure
competition on this point, the comparison is legitimate only for industries in which pure
competition can exist.

In an industry with a limited market relative to the most efficient rate of output of the
most efficient size of the plant, monopoly may result in lower cost or greater efficiency that
would occur, if these were many firms, each with a considerably less than most efficient
size of plant.

Sales Promotion
It may be to the advantage of the monopolist, be engaged in some sale promotion
activities of this kind. The monopolist may use sales promotion to enlarge his market, that
is, to shift his demand curve to the right. Consider for example, the advertisement of
monopolies like the Manila Electric company and the Philippine Long Distance Telephone
Company. These monopolies advertise for several reasons: to enlarge their respective
markets, to promote goodwill or good public relations with consumers, and to make the
public aware that their companies exist and is doing

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