MODULE BASIC MICROECONOMICS

CHAPTER 1: INTRODUCTION TO ECONOMIC THEORY

Objectives:
1. Define basic economic terms.
2. Identify the elements involved in the objective of satisfying wants.
3. Differentiate economic analysis and economic policy.
4. Describe the methodology used in the scientific approach in studying
economics.
5. Itemized the characteristics of microeconomics.
6. Apply the use of economic models in economic analysis.
7. Present an overview of the circular flow in the economy.
8. Differentiate the types of economic systems.

INTRODUCTION
Over the past years, the study of economics has widened to encompass a wider scope of
topics. Samuelson and Nordhaus’ Economics (2001) mentioned the major definitions in this
growing subject. Among these are:

1. Economics studies how prices of land,

labor, and capital are determined, and how
these prices are used to allocate scare
resources.

2. Economics looks into the behaviour of

financial market and how it allocates capital
to the rest of the economy.

3. Economics looks into the distribution of

income and into ways of helping the poor
without causing harm to the country’s
economic performance.

4. Economics studies the impact on growth of government spending, taxes, and budget deficits.

5. Economics examines the movements in income and employment during the different stages of
the business cycle with the goal of developing government policies that will improve economic
growth.

6. Economics looks at trade patterns among nations and analyses the impact of trade barriers.

7. Economics examines growth in developing countries and suggests ways to encourage the
efficient use of resources.
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ECONOMIC ACTIVITY
Man’s Basic Economic Activity

Man’s basic economic activity consists of efforts to satisfy human wants with the use of
goods and services. Three elements are involved in this objective of satisfaction as discussed in
this section.

Human wants – are unlimited and vary from the needs of survival, otherwise known as the basic
needs (e.g., food, clothing, and shelter) to higher needs for a comfortable and more meaningful
life. Economics is concerned with the satisfaction of many of these human wants especially the
basic ones.

Use of Resources: The basic economic resources of a nation consist of land, labor, capital and
entrepreneurship. These items are available in limited amounts man has to learn to allocate
them properly in order to maximize the number of wants that can be satisfied. The economy
should pay the owners of this basic factor of production for the use of their resources such as rent
for land, wage or salary for labor, interest for capital and profit for entrepreneurship.

Technique of Production – shows how resources are used and combined in production.
Production is described as capital-intensive or labor-intensive depending on what factor is
predominantly used.

In effect, the basic activities of man also constitute the basic exchange that takes place between
the business firm and the consumer.

CONSUMPTION
Household is the basic consuming unit in the economy. Since human wants are unlimited, human
maximize their satisfaction through the proper allocation or mix of expenditures within the context
of budget limitations. (For example, a student has an allowance to budget usually for a given
week. Five hundred pesos goes to transportation, sandwiches, soft drinks, and even an
occasional movie. However, a decision to buy a new T-shirt means giving up some snacks at
school as the satisfaction that will be gained from the former that will outweigh the satisfaction
foregone from the latter. The opportunity foregone is called opportunity cost.

OPPORTUNITY COST is the value of foregone alternative of a specific resource it may also be
exemplified in the earning value of a university ground had it been used as a commercial enter
instead of an educational institution.

Business firm serves as the economy’s producing unit to satisfy human wants with goods and
services.

The use of resources generates income for the resources owners. The owner of the
business has to forego the alternative use of his money to invest in the business for which he
charges interest. It is the entrepreneur who basically makes the decision as to how production
resources should be best combined to come up with the desired output.
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Some Economic Problems:

1. Unemployment

2. Economic instability that causes highs and

lows in production and investment levels.

3. Low levels of growth and development,

which make them more difficult for
underdeveloped and developing nations to
rise from their low levels of income and
employment.

4. Inequality in income distribution resulting in

the concentration of the nation’s wealth in the hands of a few.

5. Determination of the type of economic system to be adopted to meet the country’s peculiar
conditions and needs.

Unemployment is a problem because it leads to the existence of idle resources. This

means that income is foregone on resources which would generate earnings to the owner if used.

Economic instability in a nation makes it difficult for producers to make accurate

forecasts on demand and consumption that cause fluctuations in their production and supply of
goods and services resulting in surpluses or shortages of goods.

Poor countries especially suffer from low levels of economic growth and
development. They get caught in the vicious cycle of poverty, making it difficult to get started on
their development. Their low levels of income deter them from channelling fund to investments in
order to propel economic growth.

The problem of unequal income distribution exists when too many people in the
nation that belong to the low income group cause a pyramidal structure in the economy. The
wealth of the nation is concentrated in a small number of families who control the bulk of the
country’s purchasing power.

The choice of the economic system is vital to any country because it determines the
manner in which goods will be produced, the quantities of each good that will be produced, and
the distribution of these goods and services.

Economic Analysis

This is the process of directing economic relationships by examining economic behaviour

and events and determining the causal relationships among the data and activities observed. To
analyse relationship among economic variables from the particular to the general (or inductive
reasoning) or from general to the particular (deductive reasoning) necessitates the use of the first
tool of economics which is logic.

An economic analyst uses statistics to quantitatively describe economic behaviour and

therefore serves as a basis in hypothesis testing. A hypothesis becomes a principle or theory
when empirically validated.
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The third tool of economics is mathematics which enables an analyst to foresee and
assess a hypothesis for empirical validation.

Purposes of Economic Analysis:

1. Economic analysis is 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

Economic policy consists of intervention or courses of action taken by the government or

other private institutions to manipulate the results of economic activity. The economic policy
adopted by the government may be monetary, fiscal or trade for the purpose of achieving
economic welfare.

Methodology

To make useful, systematic study of economic activity, one must use economic theory.

Economic Theory

Like the theory of any other science, consists of sets of principles or causal relationship
among the important facts or variables that surround and permeate economic activity. Look first
at the construction and functions of sets of economic principles then turn to 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, that is, being without further investigation. In
economics on the other hand, may build a theory of consumer behaviour on the postulate of
consumer rationality, defined as the general desire of consumers to secure as much satisfaction
they can in spending their incomes. Therefore the first step in the construction of a theory is the
specification and definition of its postulates.

The second step is the observation of facts concerning the activity about which we want
to theorize. For example in a grocery exchange case, the hair color of a consumer is not likely to
matter, but the weekly amounts of money that consumers have to spend, the number of
supermarkets available to them, and the weekly quantities of groceries available to be purchased
will most certainly be important.

The third step – and this one will frequently be taken simultaneously with the second – the
application of the rules of logic to the observed facts in an attempt to establish causal relationship
among them and to eliminate as many irrelevant and insignificant facts as possible. Deductive
chains of ‘logic can state that certain effects follow certain causes in a regular manner. We may
reason that because consumer with a larger income is likely to lead to a higher prices. On the
other hand, we can reason inductively. Repeated observations can indicate that increase in
consumer incomes and increase in prices occur simultaneously. With these means, we reach the
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tentative conclusion that higher incomes cause prices to rise. Such tentative statements of cause
and effect relationships are called hypotheses.

The fourth step is a crucial one. Once hypotheses have been formulated, they must be
thoroughly tested to determine the extent of which they are valid, that is, the extent to which they
yield good explanations and predictions. It would be foolish to regard a set of principles or a theory
of absolute truth. The testing process in economics and in other sciences never ends. Economic
theory is not a once-and-for-all set of principles. It is continually evolving and growing.

The Functions of Economic Theory

The function of economic theory fall into two categories (1) to explain the nature of
economic activity; and (2) to predict what will happen to the economy as facts change. The
explanation of the nature of economic activity enables us to understand the economic
environment ib which we live. We would also like to be able to preddict with some degree of
accuracy what is likely to happen to the key variables that affect our well-being and to be able to
do something about thyem if we dislike the predicted consequences.

Economists differentiate positive and normative economics on the basis of whether the
users of theory are concerned with causal relationships only, or they intend some kind of
intervention in economic activity to the course of that activity.

Positive Economics – is completely objective, limited to the cause-and-effect relationships of

economic activity, it is concerned with the way economic relationships are.

Normative Economics – is concerned with what we ought to be.

Economic Policy Making – conscious intervention in economic activity with the intent of altering
the course that it will take is essentially normative in character.

But, if the economic policy making is to be effective in improving economic well being, it
must obviously be rooted in sound positive economic analysis. Policy makers should be cognizant
of the full range of consequences of the policies they recoomend.

PRICE THEORY AND ECONOMIC THEORY

Price theory (microeconomics theory) and the theory of the economy as a
whole(macroeconomic theory) constitute the basic analytical tool kit of the discipline of
economics. Both of their principles are applied to special subject areas such as monetary,
economics, international finance, public finance, manpower economics, agricultural economics,
regional economics and so on. Both theories are essential to a thorough understanding of
economic activity.

Microeconomics – is concerned primarily with the market activities on individual economic

economic units such as consumers, resource owners, and business firms. It is concerned with
the flow of goods and services from business firms to consumers.

Macroeconomics – treats the economic system as a whole rather than individual economic units
of which it is composed.

Price index numbers or general price level concepts in macroeconomics replace the
relative price concepts for individual goods used in microeconomics. Price theory is abstract
because it does not and cannot encompass all the economic data of the real world.
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Characteristics of Microeconomics:

As mentioned earlier, microeconomics is concerned with the process of resource

allocation by individual decision units or markets. It is also concerned with efficiency with which
these resources are allocated. From this definition, some characteristics can be deduced. Among
them are:

1. Microeconomics looks at the decisions of individual units. It focuses on the choices mabe by
individual decision units such as households, producers, and firms. Resource allocation
decisions are made by these individuals entities in a market economy. It is necessary to
understand their decision in order to understand the economic system.

2. Microeconomics, often called price theory, looks at how prices are determined in various types
of market structures such as pure competition, monopoly, monopolistic competition, and
oligopoly.

3. Microeconomics s concerned with social welfare. It examines the effeciency, relative

desirability, and choice of alternative methds by which resources are utilized to alleviate
scarcity. This branch of microeconomics is termed “welfare economics”.

4. Microeconomics has limited focus. It is just a part of economic discipline. It does not examine
the processes or efficiency of allocation in alternative types of economic systems, such as
socialistic planned economy.

5. Microeconomics develops skills. The study of microeconomics helps develop a set of useful
and marketable skills as follows:

a) Micoeconomics helps develop logical reasoning.

b) Microeconomics helps develop skill in the construction and use of the major skills
economists teach to the business community.
c) Microeconomics employs optimizing techniques that are useful fro making decisions
in a variety of situations.
d) The concepts studied in microeconomics are applicable to personal resource
allocation decisions, such as career choices or financial investments.

Economic Models

Microeconomics makes extensive use of modeling, comparative statistics, and

mathematics. Economic models are composed of a series of statements of assumptions or given
and statements of implications or deductions The statement describes the essential features of
an item or process and the interrelationships between factors or variables model.

The competitive market or “supply and demand” is one of the best-known economic
model. The supply and demand relationships can be expressed in three different forms: verbal
(or logical), mathematical, and graphical.

The Law of Supply can be expressed in the following words:Supply is a schedule of prices
and quantities that a supplier/s are willing to offer for sale at each price per period of time. These
suppliers would be encouraged to sell more at higher prices and would sell less at lower prices.
This is because higher prices, other things being constant, mean higher profits, and lower prices
mean lower profits.
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The verbal explanation of the Law of Supply can be expressed in mathematical notations
too. Mathematical notations are shortcut representation of verbal explanations. The Law of
Supply canbe expreseed succinctly in an equation.

Qs = 500P

The equation Qs = 500P means that if the price is, say, ₱1, quantity supplied (Qs) would
be ₱500 (500 x 1 = 500); if the price is ₱3, quantity supplied would be ₱1,500 (500 x 3 = 1,500);
if the price is ₱6, quantity supplied would be ₱3,000 (500 x 6 = 3,000). Thus we can see that there
is direct relationship between the price and the quantity supplied as explained earlier.

The Law of Supply can also be expressed graphically. If we use the given raw data and
compute the supply schedule as expressed in the equation, Qs = 500P, we will derive the
following data:

Table 1: Supply Schedule Figure 1: Suppy Schedule in Graph Form

Price Quantity Supplied 3500

1 500 3000
2500
2 1,000
2000
3 1,500 1500
4 2,000 1000
5 2,500 500
0
6 3,000 1 2 3 4 5 6

Table 1 can also be expressed in Figure 1 . Price (in peso)

Models Are Abstraction

Based on our previous discussion, a common feature of all models is that they focus only
on the essential elements of an object or process. In our example, we analyzed the behavior of
supply only from the point of view of varying prices. We mentioned that if prices are high, quantity
supplied will also be high . Clearly we know that supply of commodities is affected by other factors.

From our discussion, we can say that microeconomics is concerned with three types of
models.

1. Models to explain the resource allocation or “choice” decisions of individual household,

producers, and firms.

2. Models to explain how prices and quantities exchanged are determined in various, types of
market structure.

3. Models to examine the market economy as an interrelated system (general equilibrium model).
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An Example of a Model

Intervention in the energy industry has been practiced by government in at least four
forms: price and tax administration, licensing, rationing, and corporate participation in the
industry.One an attempt a theoretical construct to defend government presence in an oligopoly
industry like oil refining and marketing. It has been demonstrated in earlier works in oligopoly
theory that a government purchase entry into an oligopoly industry can improve short-run market
performance by inducing an increase in total industry outpurt.

Borrowing from those pioneering works and using simplifying assumptions, it can be
illustrated that government presence in the petroleum refining/marketing sector should be able to
maximize industry output relative to a purely private oligopoly situation that operates in the fashion
of a joint monopoly.

One can conceive of two sales policy options that government can take. We can call one
sales neutral strategy in the sense that regardless of the price it sets, it leaves the elasticity of
demand facing the private firms the same as before the entry of government. The other is the
discriminatory sales policy in gthe sense that it elects to sell the product to buyers who are
prepared to pay higher prices for the commodity. This can happen only if it is the low price seller
in the market and is so tolerated by the private firms.

In turn, the private firms can follow any of the three price strategies I reaction to the price
set by the government firm.

Strategy A.Select a price level that will maximize joint monopoly profits after allowing the
government firm to sell all it can at the price that it selects. Private firms will end up
pricing above the government’s price level.

Strategy B. Price within the government firm’s price level and sell all the market will clear up to
the extent of its (private) capacity.

Strategy C. Match the government price in cooperative fashion and share the market
proportionately.

The three types of models microeconomics is concerned with: resource allocation

decisions, and market economy as an interrelated system found in a market model called
“oligopoly”.

Comparative Statistics vs Dynamic Analysis

Comparative Statistics – focuses on the shift in equilibrium positions (statics) for an individual
decision unit, a market, or an economic system. Microeconomics extensively uses comparative
statistics analysis.

Equilibrium – refers to a state in which there is a balance of internal forces and no tendency for
the situation to change unless outside forces intervene. A system in such equilibrium may also be
termed “static”.

Dynamic Analysis – focuses on the pattern and rate of change for some variables between point
in times.
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Partial vs General Equilibrium

Partial Equilibrium Analysis – compares equilibrium changes for one decision unit or one
market independent of related changes in the economic system. It assumes for the purpose of
analysis that other factors will remain the same (i.e., ceteris paribus assumption). For example,
we know that the demand for a commodity depend on its price (other things being constant).
Demand for the commodity can thus be expressed as: Qd = f(P)

General Equilibrium Analysis – recognizes the interdependence of all the decisions units and
all markets in the economic system. It examines changes within the context of the entire system.
All variables are allowed to adjust in response to the initial change The changes are then
incorporated into the calculations. For xample, we know that the demand for s commodity
depends not only on its price (P), but also on income (Y), population (Po), price expectations (Pe),
advertising and promotion (Ad), amnog other things. This attempts to include all possible variables
that would affect demand all under the generalequilibrium analysis. A more realistic demand
equation can no be expressed as: Qd = f ( P, Y, Po, Pe, Ad)

AN OVERVIEW OF THE ECONOMY

The Circular Flow of Economic Activity

Within the economy, the basic activities of production, consumption, employment, and
income generation take place through the interrelationship existing between the basic consuming
unit, which is the household, and the basic producing unit, Which is the firm.

Figure 2: Model of Economic Circular Flow

A simplified model of this circular flow

of economic activity is shown in Figure
2.

The circular flow shows the flow of

money and the flow of godds and
services in both directions. The
financial flow, which is the money flow,
is depicted in the money payment by
the firm to the household of its money
income, and by the household to the
firm for its purchase of goods and
services. On the other hand, the
physical flow, which is the goods flow,
is depicted in the flow of goods and
services from the firm to the household.

Basic Economic Problems

All nations, big or small, developed and underdeveloped, haave to find answers to the
following economic problems:

1. What to produce?

2. How much to produce?

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3. How to produce?

4. For whom to produce?

What to produce is a question of the types of goods society desires. Since resources are scarce,
no economy can produce every product desired by the members of society.

How much to produce refers to the quantity of each good that the economy will have to produce
to make up the total output.

How to produce is a question on the technique of production and the manner of combining
resources to come up with the desired output. Since a good can be produced with different factor
combinations and different techniques, the problem is which of these to use.

For whom to produce refers to the market to which the producers will sell their products. It refers
to how much of the wants of each conssumer is to be satisfied.

Hence, an economic system, in answering the needs of the society, has the function of
determining what goods and services to produce as well as the order of their importance. This
will naturally depend on the needs of the economy, as well as its goals and objectives. In addition,
the economic system has to perform the task of organizing productive efforts to produce the
selected goods and services in the proper quantities. Lastly, it must determine how these goods
and services should be shared among the members of the society.

TYPES OF ECONOMIC SYSTEM

Traditional Economic System – production decisions are made according to customs and
traditions. This system, while simple and easy, does not allow progress to be introduced in the
production techniques. The producers simply employ methods that have been used years before
by his ancestors. These methods are therefore antiquated as they do not allow the producers to
adjust to changes dictated by time. This is usually practiced in underdeveloped regions and in
mountainous areas where transportation and communication are practically nonexistent.

Command Economy – the answer to the basic economic problems are dictated by the
government through the head of the nation or a group of men designated by the head to make
decisions. This system is socialistic as the government owns and controls of production.The
government plans what to produce and how resources should be allocated. In such a case, the
consumer’s freedom of choice is cutailed and the system does not enable him to participate in
the decision-making process with regard to the answers to society’s basic economic problem.
Furthermore, decisions regarding the distribution of goods lie in the hands of the government, and
hence, individual preferences are not considered at all. Consumers buy what is available and may
have to do without what they want or what they need.

Market System – deals with the economic problems by considering consumer’s choices. The
indicators are consumer’s demand in the market as reflected in the prices of goods and services.
The market prices seve as signals to the producers about what goods to produce and how much
of these goods should be produced. The problem of production is therefore solved by the price
mechanism.

The Market System and the Enterprise

The market system is best described as a free enterprise where idividuals enjoy the right
of private property.The economy operates on a system of voluntary exchange and cooperation
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among private individuals and organizations. It places a hig value on individual freedom and
allows self-interest to be the motivating force.

Under the free enterprise system, the individual is free to do any of the following:

1. Purchase goods and services of his choice within the limits of his income.

2. Offer his economic resources for sale in exchange for a financial remuneration.

3. Established, a business enterprise of his choice for the production and sale of a desired
product.

Briefly described, the market economy is an economy where individuals exewrcise free
enterprise.

The Mixed Economy – The Philippine economy is a mixture of the three forms of economic
systems discussed. In a mixed economy loke ours, the questions of what to produce and how to
produce, answered predominantly through the price mechanism, are modified through
government intervention in the form of direct controls, taxes, and subsidies.

The problem to produce of for whom to produce is also solved by the price mechanism
coupled with different forms of government regulation. The economy will produce those
commodities that will satisfy the wants of those people who have the money to pay for them.
Predominantly the Philippine economy is free enterprise in nature, but the best way to describe
its economic system is mixed economy.

SUMMARY
Economics studies how prices of land, labor, and capital are determined, and how these
prices are used to allocate scarece resources.

Economics is classified into:

1. Positive Economics – concerned with the way economic relationships are.

2. Normative Economics – concerned with what ought to be.

Three Elements of Human Economic Activity

1. Human wants

2. Use of resources

3. Techniqueof production

Tools of Economics

1. Logic

2. Statistics

3. Mathematics
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Steps in Construction of Economic Theory

1. Specification and definition of its postulates.

2. Observationof “facts” concerning the activity about which we want to theorize.

3. Application of the rules of logic to the obeserved facts.

4. Testing of hypotheses – tentative statement of cause and effect relationship.

Division of Economics

Macroeconomics – treats the economic system as a whole rather than individual economic units
of which it is composed.

Microeconomics – concerned primarily with the market activities on individual economic units.

Best-known economic model is the “Law of Demand and Supply” as expressed in three
different forms; verbal/logical, mathematical, and graphical.

Three Types of Economic System

1. Traditional economic system – production decision is based on customs and traditions

2. Command economy – answers to economic problems are dictated by the government.

3. Market System – deals with the economic problems by considering consumer’s choices.

For more knowledge, please follow the link provided;

https://www.youtube.com/watch?v=_2OsMfcC7rA
https://www.youtube.com/watch?v=TZGqPtzAH5k
https://www.youtube.com/watch?v=wvwgIiP4gjY