Principles Of Economics (with Taxation and Agrarian Reform)

Chapter 1
ECONOMICS AND ITS IMPORTANCE

Learning Objectives
1. Understand the nature of Economics and its importance.

2. Know the different fields of study in Economics.

3. Learn the very basic concept and its application through the working
of a simple model.

4. Provide example of trade-off among different goods and services.

5. Distinguish the different types of economics systems.

6. Determine the relationship of the different sectors in the economy.

Key terms:

Economics normative economics

economics resources

Economic theory efficiency economic

system

Economic model descriptive economics market

economy
Variable equity command
economy
Marco economics growth stability mixed
economy

Microeconomics production possibility

opportunity cost
Frontier

Positive economics scarce resources

Circular flow diagram unlimited wants

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Principles Of Economics (with Taxation and Agrarian Reform)

ECONOMICS AND ITS IMPORTANCE

Economics is first and foremost the study of human, behavior in

making choices. A household faces many decisions. It must decide who
among the households will do such task and what each member gets in
return. Who cooks breakfast, who does the laundry, etc. In other words,
the household must allocate its scarce resources among its various
members taking into account each member’s abilities, efforts and desires.

However, these choices when aggregated explain societal choices in

production, consumption, exchange and distribution. Like a household, a
society faces many decisions on what jobs will be done and who will do
them. It needs some people to grow food, other people to make clothing
and others to design computer software. Once the society has managed
to allocate its scarce resources, it must also allocate the economy’s
output of goods and services that they produce to improve the country’s
standard of living.

The management of the society’s resources is important because

resources are scarce. Scarcity means that society has less to offer than
people wish to have. Just as a household cannot give every member
everything he or she wants, a society cannot give every individual the
highest standard of living to which he or she might aspire.

Economics is a social science concerned with the efficient

allocation and utilization of scarce resources for the satisfaction
of the society’s unlimited wants and needs.

In most societies, resources are allocated not by a single central

planner but through the combined actions of millions of households and
firms. Economists therefore study how people make decisions; how much
they work, what they purchase, how much they save out of their income
and how they invest their savings. Economists also study how people
interact with one another. For instance, they determine how the buyers
and sellers of a good together determine the price at which the goods is
sold and the quantity that is sold. Lastly, economists analyze forces and
trends that affect the whole economy.

Methodology of Economics

The study of economic behavior starts from an economic theory.

Economic theory is an attempt to find explanations for observed
economic phenomena. Its usefulness aims for the establishment of a
cause and effect relationship. It helps us understand why a person makes
a certain economic decision or why a particular outcome is realized. A
formal statement of an economic theory is called economic model,

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 Principles Of Economics (with Taxation and Agrarian Reform)

usually a mathematical statement of a presumed relationship between

two or more variables. A variable is a value that can change from time to
time or from observation to observation. The most common ways of
expressing this are in words, graphs and equations. For example, it the
Law of Demand in which graphically the principle could be validated with
the derivation of the demand curve and the use of the demand functions.

There are 2 major divisions of economics: macroeconomics and

microeconomics.

Microeconomics is the branch of economics that examines the

functioning of the individual industries and the behavior of individual
decision making units – that is business firms and households.

Macroeconomics is the branch of economics that examines the

economic behavior of aggregate economic variables such as income,
output, employment, investment and general level of prices.

Division of
Economics Production Prices Income Employme
nt

Production/outpu Prices of Distribution of Employment

t in individual individual goods incomes and by individual
industries and services. wealth Ex. Wages businesses
MICROECONO Ex. How much Prices of medical in garment and
MICS textile, how care. Ex. Prices of industry, industries.
many cars gasoline, rent of minimum wage Ex. Jobs in
apartment, food the garment
prices industry,
number of
employees in
a firm.

National/Producti Aggregate price National Income Employment

on output Ex. level, consumer Total wages and and
MACROECONO Total industry prices, producer salaries, Total Unemployme
MICS output, GDP/GNP prices, inflation Corporate Profits nt in the
rate economy,
Total number
of jobs

Table 1.1 Examples of Macroeconomic and Microeconomic

Concern

The two kinds of questions that economists attempt to answer:

positive and normative.

Positive Economics seeks to understand the behavior and the

operation of the economic system without making judgments about
whether the outcomes are good or bad. It describes what exists and how
it works. Ex. What determines wage rates in the rural areas? What would

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Principles Of Economics (with Taxation and Agrarian Reform)

happen if we abolished the corporate income tax? Answers for these

questions are the subject of positive economics.

In contrast, Normative Economics looks at the outcomes of

economic behavior and asks if they are good or bad whether they can be
made better. It involves judgments and prescriptions for causes of action.
Normative economics is often called policy economics. Ex. Should the
government subsidizes the cost of higher education?

Positive Economics is divided into two: descriptive economics and

economic theory.

1. Descriptive Economics is simply the collection and presentation of

data that describe phenomena and facts. Ex. In the Phil., the
National Statistics Office produces an enormous amount of date, as
do the NEDA and other non-government agencies.

2. Economic Theory is a statement of a set or sets of related

statements about cause and effect, action and reaction. Ex. Law of
Demand, which states that as price increases, quantity demanded
decreases and vice versa, assuming other factors to be remaining
constant.

It helps us understand how the world works, but the formulation of the
economic policy requires a second step. It requires us to be specific about
the grounds for judging one outcome superior to another.

Criteria for Judging Outcomes.

1. Efficiency. In economics, efficiency means allocative efficiency. An

efficient economy is one that produces what people want at the
least possible cost. Ex. If the economy allocates resources to the
production of things that nobody wants, it is inefficient.

2. Equity. It implies a more equitable distribution of income and

wealth.

3. Growth. An increase in the total output of an economy It output

grows faster than population, output per capita rises and standard
of living increases.

4. Stability. A condition in which national output is steady or growing

with low inflation and full employment of resources.

Foundation of Economics

The economizing problem comprises two fundamental facts and

provides a foundation for economics.

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Principles Of Economics (with Taxation and Agrarian Reform)

1. Scarce/limited resources

2. Society’s unlimited wants

Unlimited Wants
What is economic wants? This is the desire of consumers to obtain
satisfaction from the various goods and services they consume. It covers
a wide range of products from necessities (food, shelter, and clothing) to
luxuries (cars, mobile phones, etc.)

Firms and government agencies also strive to satisfy economic

goals. To achieve this, they need capital investment and social
infrastructures.

All these wants are unlimited. In other words, individuals and

institutions have innumerable unfilled wants. The objective of all
economic activity is to fulfill wants.

Scarce Resources

Economic resources refer to all natural, human and manufactured

resources that go into the production and services that includes factory,
equipments, tools, machinery, transportation and communication
facilities, all types of labor, land and mineral services.

Four Categories of Economic Resources

1. Land – it includes all natural resources – all gifts of nature that we

used in the production process.

The income received from these resources in rent/rental income.

Ex. Arable land, forests, mineral and oil deposits, water resources

2. Labor – refer to all the physical and mental talents of individuals

available and usable in producing goods and services. The income
realized to those who supply labor is called wages that include
salaries and all wage and salary supplements such as bonuses,
commissions and royalties.
Ex. Teachers, engineers, factory workers, physicians, professional
basketball players

3. Capital – includes all produced goods used again to produce

consumer goods and services. The income received from using
capital is interest income.

Ex. Tools, machinery, equipment.

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Principles Of Economics (with Taxation and Agrarian Reform)

4. Entrepreneur – an individual who combine land, capital and labor

to produced goods or service. The entrepreneurial income is called
profits.

Economic System

Every society needs to develop an economic system – which is a

set of institutional arrangements and a group of coordinating mechanisms
that respond to the economizing problem. Economic system differs as to:

1. Who own the factors of production

2. Method used to coordinate and direct economic activity

The three types of economic system are:

1. Market Economy (Capitalism). There is private ownership of

economic resources and the use of market and prices to
coordinate and direct economic activity.

2. Command Economy (Communism). Government owns most

property resources and there is central economic planning.

3. Mixed Economy (Socialism). An economic system wherein the

basic or key industries are either owned or controlled by the
government or by the people collectively.

Economic Model

All models simplify reality in order to improve our understanding of

it. The economy consists of millions of people engaged in many activities
– buying, selling, manufacturing and so on. To understand how the
economy is organized and work, we need a model that would explain it
further.

1. Circular Flow Diagram. A visual model of the economy that

shows the income received and payments made by each sector of
the economy. In this model (2 sector), the economy has two types
of decision makers – households and firms. The inner loop of the
diagram (Fig. 1)) represents the flow of goods and services using
the inputs such as labor, land and capital combined efficiently by
the entrepreneur. These inputs are known as the factors of
production owned by the household who in return consume all the
goods and services produced by the firm.

Households and firms interact in two types of markets. In the

product market, households are buyers and firms are sellers. Households
buy the goods and services produced by the firm. In the resource

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Principles Of Economics (with Taxation and Agrarian Reform)

market, households are sellers and firms are buyers. Households are the
provider of the inputs that firms used to produce goods and services.

The outer loop of the diagram represents the flow of payments or

income. The households spend money to buy goods and services from
the firm. From the revenue that the firms realized, a part of it will be used
to p ay for the payments of inputs such as wages for the workers, rental
also member of households. Hence, payment for goods and services
flows from the household to firm, and money income in the form of wages,
rent and profit flows from firms to households.

Fig. 1.1 The Circular Flow Chart n a Two Sector Model, No Saving
Economy
PRODUCT MARKET
Revenue Firm Sell, Expenditures
Household Buy

Goods and f Goods and

Services Sold Services Bought

FIRMS HOUSEHOLDS
Produce and Sell Purchase and
Goods and Consume
Services Own and Sell
Inputs For Inputs of
Labor and
RESOURCE MARKET
Production Capital
Household Sell
Firm Buy

Wages, Rent, Profit Money Income

Fig. 1.2 The Circular Flow Chart in a Two-Sector
f Model, Saving Economy
Consumption Expenditures
(Purchase of Goods and Services)

Output of Goods & Services

Businesses Households

Land, Labor, Capital

Factors of Production

(Rent, Wages, Interest, Profits)

Money Income
Investment Household
Spending Saving

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Principles Of Economics (with Taxation and Agrarian Reform)

The savings of the household is a leakage in the circular flow i.e. a

saving leakage. Figure 1.2 shows that household savings would not result
to a decrease in government spending if it is loaned up to business firms
to finance investment. If production depends upon the relationship of
revenues of businesses and disbursement of money income, if follows
that the value of the output depends upon the households decision to
consume and save and the businesses intention to invest.

Fig. 1.3 The Circular Flow in a Three-Sector Model

Consumption
Expenditures
Output of Goods
and Services

Government Businesses Household

Factors of Production

Money Income

Investment
household
Spending
Saving

Taxes

The government collects taxes and spends it for different

government expenses. Figure 1.3 shows that taxes impose on the value
of output decreases the money flow to the household. Tax receipts if not
spent, are leakages in the circular flow. The circular flow of money
income depends upon the household’s intention to consume, businesses
intention to invest and the government’s plan to tax and spend.

Fig. 1.4 The Circular Flow in a Four Sector Model

Exports
Gov’t Expenditures

Consumption
Expenditutes

Output of
Goods
and Services

Rest of the World Gov’t Business Household

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Principles Of Economics (with Taxation and Agrarian Reform)

Factors of Production

Money Income

Investment
Household

Spending Saving

Taxes

Imports

Imports, taxes and savings is a leakage in the circular flow. Imports

do not remain in the circular flow therefore it constitutes outflows.
Exports and investment spending is an injection. From exports the
economy retrieve funds for the circular flow through the receipts of sales
from the rest of the world. The circular flow showing this outflows and
injections is drawn in Figure 1.4

2. Production Possibility Frontier. A graph that shows the various

combination of two commodities that the economy can possibly
produce given the available factors of production and available
production technology.

Because resources are scarce, a full-employment full production

economy cannot have an unlimited output of goods and services. People
must choose which goods and services to produce and which to forego.
The necessity and consequences of these choices can best be understood
through a production possibilities model.

Assumptions:

1. Full employment and productive efficiency. Full employment means

the economy make use of all its available resources while
productive efficiency is production of goods and services in the least
costly way.

2. Fixed resources. The available resources are fixed both in quantity

and quality.

3. Fixed technology. The methods used to produce output do not

change.

4. Two goods.

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Principles Of Economics (with Taxation and Agrarian Reform)

Table 1.2 Production Possibility Schedule of Clothing and

Machinery with Full Employment and Productive Efficiency

Type of Product Production Alternatives

A B C D
E
Clothing (in hundred thousand)
0 1 2 3
Machinery (in thousand) 4

10 9 7
4 0

Fig 1.5 The Production Possibility Curve

Each point on the PPC represents some maximum output of the 2

products. The curve is a production frontier because it shows the limit of
attainable output.

At point A, the economy would be devoting all of its resources in the

production of machinery while on point E all of its resources would be
utilized for clothing production. These two alternatives are unrealistic
extremes because an economy typically produces both capital and

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consumer goods as in B, C, D and E. Moving from alternative A to E,

production of clothing increases at the expense of machinery production.

To achieve the various combinations of clothing and machinery that

fall on the PPC, the society must achieve both full employment and
productive efficiency Point lying inside (to the left, which is pt. G) of the
curve are also attainable but they reflect inefficiency. Points inside the
curve imply that the economy could have more of both clothing and
machinery if it achieved full employment and productive efficiency. Point
lying outside (to the right, which is pt. H) represents a greater output.
Point H is not attainable given the available supply of resources and
technology.

Law of Increasing Opportunity Cost

Because of the scarcity of resources relative to the unlimitedness of

human wants, people must choose among alternatives. More clothing
would mean less machineries.

The amount of other products that must be foregone to obtain one

unit of a specific good is called “opportunity cost”. From alternative A
to B, in fig. 1.5, the cost of one unit of clothing is less than one unit of
machinery. But considering the cost through the additional production
alternatives, B to C, C to D and D to E – the cost foregone for each
additional unit of clothing is greater than the opportunity cost of the
preceding one. For example, from A to B – 1 thousand units of machinery
for 1 hundred thousand units of clothing, B to C – 2 thousand units of
machinery for 1 hundred thousand more units of clothing, C to D – 3
thousand units of machinery for 1 hundred thousand more units of
clothing and D to E – 4 thousand more units of machinery for 1 hundred
thousand units of clothing.

Important Points About the Opportunity Cost.

1. In this example, opportunity costs are being measured in real terms

rather than in money terms.

2. Marginal (additional) opportunity cost rather than cumulative or

total opportunity cost are discussed.

Ex. The marginal opportunity cost of the 2 hundred thousand units

of clothing I 3 thousand units of machinery, that is (=10 – 7). The
total opportunity costs for the 2 hundred thousand units of clothing
is 3 thousand units of machinery (= 1 thousand units of machinery
for 1 hundred thousand units of clothing plus 2 thousand units of
machinery for another hundred thousand units of clothing).

This example illustrate the Law of Increasing Opportunity Costs

which states that the more unit of a product is produced, the greater is
the opportunity cost.

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Principles Of Economics (with Taxation and Agrarian Reform)

Appendix:
Graphs and their meaning
Graphs are most often used to illustrate economic models. It helps
an individual visualize and understand economic relationships. Most of
the economic principles or models that explain relationships between two
sets of economic facts can be conveniently represented with two-
dimensional graphs.

Construction of a Graph

A graph is a visual representation of the relationship between tow

variables.

Table 1.3 is a hypothetical example that shows the direct

relationship between two variables.

Y C Pt.

0 75 A

100 150 B

200 225 C

300 300 D

400 375 E

500 450 F

Fig. 1.6 shows graphically how consumption changes as income changes.

Income as the in dependent variable represents the horizontal axis and
consumption as the dependent variable represents the vertical axis as
customary.

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Principles Of Economics (with Taxation and Agrarian Reform)

The vertical and horizontal of the graph is arranged to reflect the range of
values of consumption and income and the scales are marked in
convenient increment. The values marked on the scales cover all the
value in Table 1.3

Each point on the graph represents an income value and its

associated consumption value. To plot the point that represents one of
the income-consumption combination in Table 1.3 a perpendicular line
was drawn from the appropriate values on the vertical and horizontal
axes. For example, to plot pt. D (the 300 income – 300 consumption
point), perpendiculars were drawn up from the horizontal (income) axis at
300 and across from the vertical (consumption) axis at 300. The
perpendicular intersects at point D representing a particular income-
consumption combination. A line or smooth curve was drawn to connect
all income-combination points. The line represents the income-
consumption line showing that the relationship is linear.

Direct and Inverse Relationships

The positively slope line depicts the relationship between income

and consumption. A direct relationship implies that two variables change
in the same direction. An increase in consumption is associated with an
increase in income and vice versa.

In contrast, two sets of data maybe inversely related. Table 1.4 and
Fig. 1.7 shows the relationship between the price of pizza and quantity
purchased at a pizza chain. The figure shows an inverse relationship
because two variables change in opposite directions. When pizza price
increases, the quantity purchased decrease and vice versa. The seven
data points in Table 4 are plotted in Figure 1.7.

Table 1.4 The Relationship Between Pizza Prices and Quantity

Purchased

Pizza Price Quantity Purchased Pt.

100 0 A

85 3 B

70 6 C

55 9 D

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Fig.
1.7

Dependent and Independent Variables

The independent variable is the cause or source and the one that
changes first. The dependent variable is the effect in outcome and it
changes because of the change in the independent variable. In the
income consumption example, income is the independent while
consumption is the dependent. Similarly, in example 2, the quantity of
pizza purchased is the dependent variable.

In mathematics, mathematicians always put the independent

variable on the horizontal axis and the dependent variable on the vertical
axis. Economist way of graphing the dependent and independent variable
is more arbitrary. Their graphical presentation of income-consumption
relationship is consistent with mathematical presentation but with respect
to price and cost data they put it on the vertical axis. Hence, graphing
price and quantity purchased data conflicts with normal mathematical
procedure.

Other Things Equal

When economists plot the relationship between any two variables
the ceteris paribus (other things equal) assumption is employed.

Thus, in Fig. 1.6, all factors other than income that might affect
consumption are presumed to be constant. Similarly, in Fig. 1.7, all

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Principles Of Economics (with Taxation and Agrarian Reform)

factors other than pizza price that might affect quantity purchased are
assumed unchanged.

In reality, other things are not equal. They often change and when
they change, the relationship presented in the two tables and graphs will
change and the lines plotted on the graph will shift to new locations.

Slope of a Line

Lines are described in terms of their slopes. The slope of the

straight line is the ratio of the vertical (Y axis) change to the horizontal
change (X axis) change between any two points of the line.

Positive Slope:

Between pt. C to D in gif. 1.6, the vertical change is P75 and the
horizontal change is P100, therefore:

Vertical change
Slope =
horizontal change

75

100

.75

The slope of .75 is positive because consumption and income

change in the same direction.

Negative Slope

Between any two of the identified points in Fig. 1.7 say point B to C,
the vertical change is – 15 and the horizontal change is 3. Therefore:

-15
Slope = 3

= -.5

The slope is negative because the pizza price and quantity

purchased have an inverse relationship. The slope of -.5 means that
lowering the price by 15 will increase quantity purchased by 3.

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Principles Of Economics (with Taxation and Agrarian Reform)

Infinite and Zero Slopes

Many variables are unrelated or independent of one another. For

ex. The quantity of mobile phones purchased is not related to the price
of mangoes. Fig. 1.8 (a) represents the price of mangoes on the
vertical axis and the quantity of mobile phones on the horizontal axis.
The relationship is represented by a line parallel to the vertical axis
implying that the same quantity of mobile phones is purchased no
matter what is the price of mangoes. The slope of the line is infinite.

Fig. 1.8 c

Price of Infinite
Mango
Zero

Quantity of Annulment
Mobile Phone Rate
(a)
(b)

Similarly, total consumption is completely unrelated to the nation’s

annulment rate. The line parallel to the horizontal axis represents lack
of unrelatedness that shows a zero slope (Fig. 1.8 (b)).

Vertical Intercept

Without plotting the points, a line can be located on the graph if we

know its slope and vertical intercept.

The vertical intercept of a line is the point where the line meets the
vertical axis. In Fig. 1.6, the vertical intercept is P75, which means that
if the current income is zero, consumers would still spend P75 and they
could do this through borrowing or selling some of their assets. In Fig.
1.7 P100 is the vertical intercept, which shows that at the price of P100
no pizza would be purchased because of its higher price.

Equation of a Linear Relationship

In its general form, the equation of a straight line is:

Y = a + bX

Where: Y = dependent variable

a = vertical intercept

b = slope the line

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Principles Of Economics (with Taxation and Agrarian Reform)

X = independent variable

From the income-consumption example in Table 1.3, if C represent

Consumption (the dependent variable) and Y represents income
(independent variable), the equation will be written as C = a + bY. By .
75Y. This equation would allow us to determine the amount of
consumption for every level of income. In figure 2, if P represents the
independent variable and Q represents thee dependent variable, their
relationship is given by:

P = 100 – 5Q

Where the vertical intercept is 100 and the negative slope is -5.

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Principles Of Economics (with Taxation and Agrarian Reform)

Name:________________________________________________ Score __________

Section ________________ Room: _________________________Date: __________

Exercise 1.1
TRUE OR FALSE.

_________ 1. In the circular flow diagram, households receive income

through the product market.

__________2. The resource market is where household buy goods, services,

and businesses sell goods and services.

__________3. The price of a new mobile phone can be determined in the

product market.

__________4. In the circular flow diagram, household spends income in the

resource market.

__________5. Money is considered as a capital resource in economics.

__________6. Failure of the economy to achieve productive efficiency

causes an economy to operate at a point inside its PPC.

__________7. All points on the PPC represent productive efficiency.

__________8. PPC is bowed out from the point of origin because it reflects
the law of increasing opportunity cost.

__________9. Economic efficiency embodies full employment and full

production.

__________10. In the circular flow diagram 2 sector model, businesses are

on the buying side of the product market and selling side
of the resource market.

__________11. Households are on the selling side of the resource market

and buying side of the product market.

__________12. Economics is grounded on two basic facts: limited wants

and unlimited resources.

__________13. A workers salary could be determined in the product

market.

__________14. Descriptive economics is designed to identify and solve

problems to the greatest extent possible and at the least
possible cost.

__________15. Normative economics express value judgment.

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Principles Of Economics (with Taxation and Agrarian Reform)

Name: _________________________________________________ Score_________________

Section___________ _____________Room: ___________________ Date: _________________

Exercise 1.2

A. Indicate which of the following statement applies to microeconomics or

macroeconomics.

1. Unemployment rate of the Phil. For the 2nd quarter of 2004 is 13.7%

2. Total exports as of June 2004 is $3.313B and total imports are $3.28B.

3. Consumer Price Index rose by 3%

4. ABC Corporation laid off 5% of their employees.

5. Commercial Banks raise its interest rate on industrial loans by 2.5%

6. A 12% decline in the production output in the garment industry.

7. Minimum wage in Metro Manila area is P285.00 daily.

8. Increase in prices of food products in the market.

9. Gross Domestic Product rise by 5.2%

10.Laborers demand for a 40% increase in daily wage.

B. Identify each of the following statement either as positive or normative.

1. The unemployment rate of the Phil. As of April 2004 is 18.5%

2. Inflation reduces the purchasing power of an individual.

3. Educational institutions must re-engineer their curriculum to be

responsive to the needs of the industry.

4. The government is in fiscal crisis.

5. Lawmakers should formulate sound economic policies.

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Principles Of Economics (with Taxation and Agrarian Reform)

Name: _________________________________________________ Score_________________

Section________________________Room: ___________________ Date: _________________
Exercise 1.3

A. Given below is a hypothetical production possibility schedule of an

economy producing only two goods, food and automobile. It shows the
various combinations of food and automobile that the economy can
produce in a given period.

Production Unit of Food Unit of Automobile

Alternative (in hundred (in thousand)
thousand)

A 0 15

B 1 13

C 2 10

D 3 5

E 4 0

Q. Graph the economy’s production possibility curve

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B. Fill in the blanks or choose the correct alternatives.

1. The numbers in the production possibility schedule stand for the

(physical quantities, money values) of food and automobile.

2. The numbers represent the (maximum, minimum) amounts of food and

automobile that the economy can produce with its available resources.

3. If all of the resources were devoted to food production, _____ units of

clothing and _______units of automobile will be produced.

4. If the economy wishes to produced thirteen thousand units of

automobile, _____ units of food will be produced.

5. If the economy decreases the production of automobile from thirteen

to ten thousand, food production will be increased by ____ units.

6. If the economy increases production of food from one to two thousand,

automobile production decreases by _____ units.

7. If economy (can, cannot) produces thirteen thousand of automobile

and two hundred thousand units of food because such combination is
(within, beyond) the available resources of the economy.

8. The economy (would, would not) produce the ten thousand units of
automobile and two hundred thousand units of food because such a
combination means that the economy (is, is no t) maximizing the
resources.

C. A technological innovation makes it possible to increase production of

automobile by 5%.

Construct a new production possibility schedule.

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Principles Of Economics (with Taxation and Agrarian Reform)

Name: _________________________________________________ Score_________________

Section________________________Room: ___________________ Date: _________________

Exercise 1.4

A. Provide examples of each type of economic system. Classify the

Philippines according to the type of economic system and explain your
answer.

B. Complete the statements below by matching them with the correct terms.

• Competition

• Each person

• Freedom of exchange

• Profits

• Self interest

1. In a pure market economy, ______________makes basic economic

decisions

2. Market system economy, _________________of buyers and sellers

3. In a market economy, ____________________allows only the most efficient

producers to succeed.

4. Producers in a market economy seeks ______________

In a market economy, people buying and selling material goods and

one another’s skills have ______________

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Principles Of Economics (with Taxation and Agrarian Reform)

DEMAND AND SUPPLY: MARKET EQUILIBRIUM

Learning Objectives
1. Get a good understanding of the meaning of demand and supply.

2. Derive demand and supply schedule and curves with the application of
demand and supply model.

3. Identify application of supply and demand and use them for analysis.

4. Examine what determines the demand and supply of goods in a

competitive market.

5. Understand how supply and demand together set the price of a good
and quantity sold.

Key terms:

Demand complementary goods change in

quantity supplied

Quantity demanded equilibrium price

equilibrium quantity

Income effect law of demand surplus

Substitution effect law of supply shortage

Primary demand individual supply

change in quantity demanded

Individual demand market supply

Market demand

Substitute goods

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Principles Of Economics (with Taxation and Agrarian Reform)

Chapter 2
DEMAND AND SUPPLY: MARKET EQUILIBRIUM

Resources are scarce and human wants are insatiable. These two
facts are the foundation or root problems of economics. How to maximize
consumer satisfaction depends on the efficient management of these
limited resources. So, the decision of choices about what and how much
goods, comes to fore. All consumers want quality life. What goods and
services do we consumers desire? Having a nice house to live in, a nice
cloth to wear, good education, having one’s own car and so forth are all-
important. But what determines what goods and services the consumer’s
want? How do consumers decide what to buy? The following sections will
help you understand the demand and how the consumers fulfill their
demand for goods and services based on their needs, income, prices and
ll possible available alternatives.

Demand and Prices

The buyers want the price that will give them the most value for the
least cost. Assuming all things are equal, with a given income, the buyer
will tend to buy more units of an item at lower prices or less units at
higher prices.

What demand? Demand is a schedule of the different quantities of

a good that the buyers are willing and able to buy at different prices at a
given time. For example, a buyer has P6 to spend for product X. the
schedule below shows the different quantities of X the buyer is willing and
able to buy corresponds to given set of prices in the market.

Demand for Product X

Price Quantity
demanded

P 0.10 60
units

0.20 30
units

0.30 20
units

0.40 15
units

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Principles Of Economics (with Taxation and Agrarian Reform)

Table 2.1

At price P0.10 the quantity demanded is 60 units. At price P0.40 the

quantity demanded is 15 units. The term, quantity demanded is the
amount of good that the buyers are willing and able to buy at some
particular price. The specific quantity of 60 units that will be bought at a
specific price of P0.10 is quantity demanded. For demand to be effective,
buyers must be willing and able to buy the goods.

Law of Demand

The law of demand indicates that as price increases, a smaller

quantity will be bought as price decreases, a larger quantity will be
bought. It indicates an inverse relationship between price and quantity
demanded.

The law of demand can also be explained in terms of income and

substitution effect.

1. Income effect means that a decrease in the price of a product will

increase the purchasing power on one’s money income; hence, you
are able to buy more of the product than before. For example, the
buyer has P20, at price P5 per unit, he can buy 4 units of the
product. If the price goes down to P2 per unit, he can n ow buy 10
units instead of 4 units.

2. Substitution effect indicates that, at a lower price, one has the

incentive to substitute the cheaper good for similar goods, which
are now relatively more expensive. For example, at a lower price,
beef is relatively more attractive and it is substituted for pork.

The income and substitution effects combine to make consumers able

and willing to buy more of a product at a low price than at a high price.

Demand curve is a graphically illustration or representation of

demand.

The curve slopes downward from left to right.

Figure 2.1

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Principles Of Economics (with Taxation and Agrarian Reform)

Types of Demand

A. Primary demand or Consumer demand

1. Individual demand

2. Market demand or collective demand

B. Derived demand or producer demand

Demand for final goods is primary demand or consumer demand

while demand for the factors of production is derived demand or producer
demand.

Demand for the factors of production like bakers, oven, yeast, flour,
and othes depends on the desire and income level of the consumers for
the final goods like bread, cakes, pastries and other bakery products.

Individual demand is the demand of an individual consumer for a

given commodity. Market demand is the sum total of individual
demand. For example, if household A, B and C comprise the entire
consuming public. Household A has an income of P10; household B, P6;
and household C. P12 for product x.

Table 2.1

Quantity Demand

Household Household Household

Market
Price A B C
Demand
P0.10 100 60 120 280
0.20 50 26 30 60 140
0.30 33 20 40 93
0.40 25 15 30 70
Principles Of Economics (with Taxation and Agrarian Reform)

Factors affecting Demand (Determinants of Demand)

1. Number of buyers.
2. Consumer income.
3. Consumers’ tastes and preferences.
4. Prices of related goods.
5. Consumer expectations with respect to future prices and income.

1. Numbers of Buyers

There will be an increase in demand if there are more buyers in the

market. Fewer buyers will be reflected by a decrease in demand.

More buyers, Demand will increase

Fewer buyers, Demand will decrease

2. Consumers’ Income

(a) Superior good or normal good is good which demand

increases as consumer income increases.

Increase in income, Demand will increase

(b) Inferior good is a good which demand decreases as consumer

income increases.

Increase in income, Demand will decreases.

(c) A decrease in consumer income will cause a decline in the

demand for a good.

Decrease in income, Demand will decrease

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Principles Of Economics (with Taxation and Agrarian Reform)

3. Consumers’ Tastes and Preferences

A favorable change in consumers’ tastes and preferences for a

product will cause demand to increase. An unfavorable change in
consumers’ tastes and preferences will cause demand to decrease.

Consumers favoring product X, Demand for X will increase

Consumers not favoring X, Demand for X will decrease

Demand is also influenced by psychological needs. Recently,

bracelets and necklaces made of semi-precious stones and beads are a
fad. Most of the women, young and old, wear these fashioned jewelries.
Why? Because others wear them, we imitate . Some items, which are
offensive at one time, may not be offensive at another time because of
the changes in fashion and tastes.

4. Prices of Related Goods

The related goods are either substitute goods or complementary
goods.

5. Substitute Goods ( or competing goods) are goods which are used

in place of other goods. For example, butter and margarine. If the
price of butter goes up, demand for margarine will increase. If the
price of butter goes down, demand will decrease. The price of one
good and the demand for the other are directly related.

Butter Margarine
Price  Demand will 
Price Demand will 

Complementary goods are goods that go together. For example,

car and gasoline. If you buy a car you must buy gasoline. If the price of
gasoline up, demand for car will decrease. If the price of gasoline goes
down, the demand for car will increase. The price of one good and the
demand for the other are inversely related.

Price of Demand for car will

Gasoline
Increases Decrease
Decreases Increase

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Principles Of Economics (with Taxation and Agrarian Reform)

6. Expectations
Consumer expectations of higher future prices may prompt them to
buy now in order to “beat” the anticipated price rises. Similarly, these
expectations of the higher future income may induce the consumers to
increase their current spending. On the other hand, consumer
expectations of lower future prices and income will cause a decrease in
the demand for the good.

Price/Income in the near

Future expected Demand today will

Increase Increase
Decrease Decrease

Changes in Quantity Demanded

A change in quality demanded is affected by the change in price. It is

a movement from one point on a fixed demand curve. For example

Shift in Demand Curve

A change in demand is affected by one or more of the

determinants of demand. “Demand” refers to a schedule or
curve; therefore, a change in demand’ must mean that the
entire schedule has change and that graphically, the cure has
shifted its position. For example

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Principles Of Economics (with Taxation and Agrarian Reform)

Fig. 2.3 (b)

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Principles Of Economics (with Taxation and Agrarian Reform)

Supply

The job of sellers is to supply what buyers demand. What and how
much will be produced and who will produce it are an important question
that directly affects us as consumers. What decisions will the sellers
make depend on many things. The following sections will help you
understand the relationship between supply and price in a market
economy.

Supply

Supply is a schedule of the different quantities of goods that the

sellers are willing and able to sell at different prices at a given time. For
example,

Table 2.3

Supply Schedule of Product X

Price Quantity Supplied

P10 0 Units

20 500 Units

30 1000 Units

40 1500 Units

50 2500 Units

No seller is willing to sell any units of X at P10. When the price is

P20, sellers are willing to supply 500 units. At P50 a unit, the sellers are
willing to supply 2,500 units. Zero units, 500 units, and 2500 units are
quantity supplied.

Quantity supplied is the amount of goods that the sellers are

willing and able to sell at some particular price. For supply to be effective,
sellers must be willing and able to sell the product.

Law of Supply

The supply schedule illustrates the law of supply: as price increases,

a larger quantity will be sold; as price decreases, a smaller quantity will be

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Principles Of Economics (with Taxation and Agrarian Reform)

sold. The law of supply indicates a direct relationship between price and
quantity supplied.

Supply curve is a graphical illustration or representation of supply.

The curve slopes upward from left to right.

Fig. 2.4

Types of Supply

1. Individual supply is the supply of an individual seller of a given

commodity.

2. Market or collective supply is the sum total of individual supply.

Example: Presented below is the supply schedule of product X by

firms A, B and C.

Table 2.4

Quantity Supply

Price Form A Form B Form C Market

Supply

P 10 10 15 7 32

20 12 20 10 42

30 14 25 13 52

40 16 30 16 62

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Principles Of Economics (with Taxation and Agrarian Reform)

50 18 35 19 72
Factors affecting supply (the determinants of supply)

1. Number of sellers

2. Changes of technology or method f production

3. Changes in the cost of production

4. Sellers expectations with respect to the future prices. (Price

expectations)

1. Number of Sellers

More sellers will increase supply. Fewer sellers will decrease

supply.

Number of sellers Supply will

More Increase

Fewer Decrease

2. Change in Technology or method of Production

If a new technology is introduced which makes it less expensive to

produce a product, there will be an increase in supply. On the other
hand, a more expensive method is used in the production; the
change decreases the amount produced at any given price
(decrease in supply).

Method of production Supply will

Less Expensive Increase

More Expensive Decrease

3. Change in the Cost of Production

Prices of human, natural and capital resources often change. These

changes affect a producer’s ability to supply goods at a certain
price. Increasing cost of production decreases supply. Decreasing
costs increases supply.

Cost of Production Supply will

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Principles Of Economics (with Taxation and Agrarian Reform)

Increase Decrease

Decrease Increase
4. Expectations

Expectations concerning future prices of a product may affect a

producer’s current willingness to supply that product. Expectations
of a higher future price will decrease the present supply curve of a
product. A fall or decline in price will increase the present supply of
a product.

Present Near Future

Decrease in Supply Increase in Price

Increase in Supply Decrease in Price

Change in Quantity Supplied

Quantity supplied is affected by the change in price. It refers to the

movement from one point to another point on a stable supply curve.

Example

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Principles Of Economics (with Taxation and Agrarian Reform)

Shift in Supply Curve

A change in supply is affected by one or more of the determinants of

supply. Like demand, “supply” refers to a schedule or curve; therefore, a
“change in supply” must mean that the entire schedule has changed and

that graphically the curve has shifted its position. Example,

Demand and Supply: Market Equilibrium

In a market economy, prices are determined by the interaction of

demand and supply, the decision of the buyers to buy and the decisions of
the sellers to sell. Buyers will buy more goods at lower prices than at
higher ones. Sellers will sell more goods at higher prices than at lower
ones. But at a certain point, there is a price, which will be satisfactory to
both the buyers and the sellers. Hence, the quantity the buyers are
willing to buy will be equal to the quantity of the sellers are willing to offer
for sale. There is no surplus or shortage exists. No pressure for the price
to change, there is a market equilibrium.

Graphically, the interaction of the demand curve and the supply curve
of the product will indicate the equilibrium point. The price and
quantity determined by the interaction are the equilibrium price and
equilibrium quantity.

Market Demand and Supply of Product X

Table 2.5

Quantity Quantity Surplus Effect on Who

bid up/

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Principles Of Economics (with Taxation and Agrarian Reform)

Demanded Price supplied or shortage the prices

lower the prices

100 units P10 30 units shortage increase

buyers

60 units 20 60 units equilibrium constant

-

20 units 30 100 units surplus decrease

sellers

Equilibrium price is the price at which quantity demanded is equal

to quality supplied.
Equilibrium quantity is the quantity exchanged at equilibrium price and
quantities are P20 and 60 units.

A surplus is a situation wherein quantity supplied is greater than

demanded. A price P30, there is an excess supply of 80 units. With such
large surplus, seller have no choice but to roll back the price toward its
equilibrium point.

A shortage is a situation wherein quantity demanded is greater

than quantity supplied. At price P10, there is an excesss demand of P70
units. When the price is below the equilibrium price, the sellers may not
supply as much of a good or service as consumers want. Competition
among the buyers for the goods will bid up to the price.

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Principles Of Economics (with Taxation and Agrarian Reform)

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Principles Of Economics (with Taxation and Agrarian Reform)

Name: Score:
Section: Room: Date:

Exercise 2.1

Fill the blanks / underline the best alternative

1. The demand schedule has two columns: and

2. The law of demand indicates a (an) (direct/inverse) relationship

between price and quantity demanded.

3. A good which demand decreases as consumer income

increases, is called good.

4. Demand for product B increases as the price of product A

declines. Products A and B are (substitute / complementary)
goods.

5. The law of demand states that as price rises buyers will

purchase (more/less/zero/the same) quantity of the product.

6. A change in the number of buyers would affect (demand /

quantity demanded).

7. A change in the price of the product would affect

(demand/quantity demanded).

8. A change in consumer income would affect (demand, quantity

demanded).

9. demand is the demand for final goods.

10. demand is sum total of individual demand.

11. Derived demand is the demand for .

12. are goods that are used together.

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Principles Of Economics (with Taxation and Agrarian Reform)

Name: Score:
Section: Room: Date:

Exercise 2.2

Presented below are the demand schedules for rice (in kilogram/month) of
three households.

Quantity Demanded By Market Market

Market

Price Household A Household B Household C Demand Demand

Demand
(1) (2) (3) (4) (5) (6)
(7)

P35 1 4 4

30 2 6 8

25 3 8 12

20 4 10 16

15 5 12 20

1. Assuming the above three households comprise the entire rice

consuming public. Compute the market demand in column (5)
above.

2. Plot the market demand curve and label it (a).

3. If the price were P30/kg.

a. How many kilograms would household a wish to buy? Kgs.

b. How many kilograms would household B wish to buy? Kgs.
c. How many kilograms would household C wish to buy? Kgs?
d. How many kilograms would the entire consuming public wish to
buy?
Kgs.

4. Household B doubles its purchase of rice. Derive the new market

demand schedule in column (6) above.

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Principles Of Economics (with Taxation and Agrarian Reform)

5. Plot the new market demand curve on the graph in No. 1 and label
it (b).

6. If the price were P30/kg.

a. How many kilograms would household A wish to buy?

Kgs.
b. How many kilograms would household B wish to buy?
Kgs.
c. How many kilograms would household C wish to buy?
Kgs
d. How many kilograms would the entire consuming public wish to
buy? Kgs
7. Household A suddenly stops buying rice. Derive the new market
demand schedule in column (7) above.
8. Plot the new demand curve on the graph in No. 1 and label it (c).
9. If the price were P30/kg.
a. How many kilograms would household A wish to buy? Kgs.
b. How many kilograms would household C wish to buy? Kgs.
c. How many kilograms would household C wish to buy? Kgs.
d. How many kilograms would the entire consuming public wish to
buy?

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Principles Of Economics (with Taxation and Agrarian Reform)

Name: Score:
Section: Room: Date:

Exercise 2.3

Which figure (A) , (B) , (C) or (D) illustrates the effect of each of the
following on the demand for product X?

1. An increase in consumer income, assuming product X is an

inferior good.

2. A decrease in the number of X buyers.

3. A decrease in the price of product Y, a substitute of

product X

4. A change in consumers’ tastes, in favor of product Y, a

complement of product X

5. An increase in the price of product X

6. A decrease in the price of product Y, a complement of

product X

7. The consumers expect the price of product X to decrease

in the near future.

8. A decrease in consumer income.

9. A decrease in the price of product X

10. An increase in the price of product Y, a substitute of

product X

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Principles Of Economics (with Taxation and Agrarian Reform)

Name: Score:
Section: Room:
Date:

Exercise 2.4

Identify the following pairs. Write C for complements and S for

substitutes.

1. Chicken and turkey

2. Gasoline and motor oil

3. Barbecue charcoal and charcoal lighter fluid

4. Coffee and tea

5. Car and gasoline

6. Ball pen and fountain pen

7. Blouse and skirt

8. Yellow taxicab and red taxicab

9. Blackboard and chalk

10. Yellow pad paper and intermediate pad paper.

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Principles Of Economics (with Taxation and Agrarian Reform)

Name:
Score:
Section: Room:
Date:

Exercise 2.5

Fill in the blanks / underline the best alternatives.

1. The supply schedule has two columns: and .

2. When more units of a commodity are offered for sale at each price,
there has been an increase in (supply, quantity supplied).

3. A movement up (down) along the supply schedule implies a change

in (supply, quantity supplied).

4. Which of the following could not cause a change in the supply of

commodity X?

a. A decrease in the price of X

b. An increase in population

c. An improvement in the method used in producing X

d. A higher wage rates in X industry

5. The law of supply indicates a (an) (direct, inverse) relationship

between price and quantity supplied.

6. A change in the prices of resources would affect (supply, quantity

supplied).

7. A change in the price would affect (supply, quantity supplied).

8. An increase in supply would shift the curve to the (left, right).

9. A decrease in supply would shift the curve to the (left, right).

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Principles Of Economics (with Taxation and Agrarian Reform)

10. Supply is the supply of an individual seller of a given

commodity.

Name: Score:
Section: Room: Dare:

Exercise 2.6

Presented below are the schedules of commodity X of 3 individual firms:

Quantity Supplied By:

Price Firm A Firm B Firm C Market Supply

Market Supply

(1) (2) (3) (4) (5) (6)

P35 1 4 4

30 2 6 8

25 3 8 12

20 4 10 16

15 5 12 20

A. Compute the market supply (5) above.

B. Plot the market supply curve and label it (a)

C. If the price of X were P30 per unit:

1. How many units of X will all sellers supply? Units

2. How many units will Firm A supply? Units

3. How many units will Firm B supply? Units

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Principles Of Economics (with Taxation and Agrarian Reform)

4. How many units will Firm C supply? Units

D. Improvements in the method in producing commodity X by Firm C

allow it to supply 5 more units at every price. Compute the new
market supply in column (6) above.

E. Plot the new Market supply curve in the graph in (B) and label it (b).

F. If the price of X were P30 per unit:

1. How many units of X will all sellers supply? Units.

2. How many units will Firm A supply? Units

3. How many units will Firm B supply? Units

4. How many units will Firm C supply? Units

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Principles Of Economics (with Taxation and Agrarian Reform)

Name:
Score:
Section: Room:
Date:

Exercise 2.7

Which figure – (A), (B), (C) or (D) – illustrate the effect of each of the
following on the supply of product X?

1. An increase in the number of X producers.

2. An increase in the price of product X

3. A change in technology which reduces the cost of producing X

4. An increase in the wage rates in X industry

5. The producers expect the price of product X to increase in the

near future.

6. The government granted a subsidy ofP1.00 per unit of product X

produced.

7. The government imposed a tax of P0.50 per unit of product X

produced.

8. A decrease in the price of product X

9. The number of firms producing X decreases

10. Firm expect the price of X to decrease in the near future.

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Principles Of Economics (with Taxation and Agrarian Reform)

Name:
Score:
Section: Room:
Date:

Exercise 2.8

Demand, Supply and Equilibrium

Matching type: Write the corresponding Capital Letter

Terms:

A. Price ceiling H. Change in demand

B. Decrease in supply I. Inferior goods

C. Increase in supply J. Normal goods

D. Decrease in quantity demanded K. Equilibrium price

E. Increase in quantity demanded L. Substitute goods

F. Change in quantity demanded M. Complementary

goods

G. Shortage N. Surplus

1. A situation that exists below the equilibrium

2. Movement of a point downward demands curve.

3. Shift of the supply curve to the right.

4. Consumers buy more of this good if their income increases.

5. Movement of as point upward or downward a demand curves.

6. The price at which quantity demanded is equal to quantity

supplied.

7. An increase in the price of one product causes a decrease in the

demand for another product.

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Principles Of Economics (with Taxation and Agrarian Reform)

8. A situation wherein quantity supplied is greater than quantity

demanded.

9. An increase in the income of the consumers causes a decrease in

the demand for these goods.

10. The demand curve shifts either to the left or to the right.
Name:_______________________________________ Score______________
Section_________________Room_________________Date_______________

Exercise 2.9

Fill in the blanks. Underline the best alternatives.

Demand Supply
Quantity Quantity
Price Price
demanded supplied
(P) (X) (P) (X)
20 4000 20 1000
40 3000 40 1500
60 2000 60 2000
80 1000 80 2500

1. From the above demand and supply schedules, the equilibrium

price and quantity are P_____ and _____ units.

2. If the price were set at P20, there would be a (surplus/shortage)

of good equal to_________units

3. If the price were set at P80, there would be a (surplus/shortage)

of good equal to_________units.

4. A surplus exists at P______price level.

5. A shortage exists at P______and P_____price levels.

6. If the price is P40, (buyers/sellers) will (bid up/lower) prices.

7. If the price isP80, (buyers/sellers) will( bid up/lower) prices.

8. If the price isP80, price will tend to (increase/decrease/remain the

same).

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Principles Of Economics (with Taxation and Agrarian Reform)

9. If the price is P20, price will tend to (increase/decrease/remain

the same).

10. If the quantity supplied is doubled at each price, level and

quantity demanded remains unchanged, the new equilibrium
price and quantity will be P______and_______units.

Name:__________________________________________________Score:_________
Section:_______________________Room:_____________________Date:__________

Exercise 2.10

Multiple choice: Write the letter:

1. I f the
demand is DD and supply is SS, the equilibrium price and quantity
will be

A. P and Q C. P and Q

B. P and Q D. P and Q

2. If demand shifts to DD with no changes in supply (SS), the new

equilibrium point will be

A. A C. C

B. B D. E

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Principles Of Economics (with Taxation and Agrarian Reform)

3. If demand is DD and supply is SS the mew equilibrium price and

quantity will be

A. P and Q C. P and Q

B. P and Q D. P and Q

4. If demand is DD and supply is SS at price P , there will be

A. A shortage of X C. an equilibrium
point

B. A surplus of X D. a price ceiling

5. If demand is D D and supply is S S, at price P , there will be

A. A shortage of X C. an
equilibrium point

B. A surplus of X D. a price ceiling

6. An increase n demand can be represented as

A. a movement from DD to D D

B. a movement form D D to DD

C. a movement up along DD or D D

D. a movement down along DD or D D

7. An increase in quantity demanded can be represented as

A/B/C/D (see question No.6)

8. An increase in supply can be represented as

A. a movement from SS to S S

B. a movement from S S to SS

C. a movement up along SS or S S

D. a movement down along SS or S S

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Principles Of Economics (with Taxation and Agrarian Reform)

9. An increase in quantity supplied can be represented as

A/B/C/D (see question No.8)

10. At price P , a movement from point F to point A indicates

A. An increase in supply

B. A decrease in supply

C. An increase in quantity supplied

D. A decrease in quantity supplied

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Principles Of Economics (with Taxation and Agrarian Reform)

Name:_________________________________________________Score:__________

Section:______________Room:_____________________________Date__________
_

Exercise 2.11

Illustrate graphically the effect of each of the following on the equilibrium

price (P) and equilibrium quantity (Q). (The following symbols stand for:
D ( demand), S ( supply), (increase), (decrease), - (constant), > (greater
than), < (less than), = (equal to)

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Principles Of Economics (with Taxation and Agrarian Reform)

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Principles Of Economics (with Taxation and Agrarian Reform)

Name:____________________________________________Score:________

Section:___________________Roo:____________________Date:_________

Exercise 2.12

Examine and indicate the effect of each of the following events on the
demand for (D), supply of (supply), equilibrium price (P) and equilibrium
(Q) of product X.

Answer code:  for increase

 for decrease

_ for constant

EVENT D P S Q
1. Series of studies that X provides
many
 –  –
Nutritional benefits for a healthy
body.
2. An increase in the price of X    –
3. An increase in consumer income
assuming X is a normal good.  –  –

4. A change in technology, which

decreases –  – 
costs of producing X.
5. Both the consumers and the
producers expect the price of X  – – 
to increase in the near future.
6. A decrease in the price of X.    
7. A decrease in the price of Y, a
substitute    
of X.
8. An increase in the prices of raw
materials –   
use in X production.
9. Medical bulletin warned that
product X
Has high cholesterol and
 – – –
saturated fat content which can
lead to gallstones and
Obesity.
10. A change in consumers’ tastes,
favoring  –  –
Y, a complement of X.

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Principles Of Economics (with Taxation and Agrarian Reform)

NATIONAL INCOME ACCOUNTING

Learning objectives

1. Know the approaches in the computation of GDP, GNP and other

national income
accounts as well as the purpose of measuring these accounts.

2. Understand related concepts such as nominal and real GDP/GNP,

price index and GDP deflator.

3. Determine the types of transaction that are included or excluded

from the measurement of GNP.

4. Solve problems and the solution through examples.

5. Explain the problem of double counting and know the approach of

summing value-added of final goods.

6. Relate nominal to real interest rate.

Key terms:

Gross national product value added

Final goods net national product

Intermediate goods national income

Real GNP personal income

Consumer price index personal

disposable income

Transfer payment personal savings

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Principles Of Economics (with Taxation and Agrarian Reform)

49

CHAPTER 3

NATIONAL INCOME ACCOUNTING

The executive of a firm wants to know how well firm is performing.

What measures should he undertake to improve the financial standing of
the firm? Accounting date provide him with the information he needs to
assess the operation of the firm. What accounting does to the firm is
what it does for the economy as a whole. National income accounts
provide the framework of the economy’s performance and the economy’s
stage of economic development. Hence policies can be formulated to
improve the performance of the economy.

Gross National Product (GNP)

Gross National Product is the market value of all final goods and
services produced in the economy during a given period of time, usually
one year.

Final Goods are goods which are for final consumption by the end
user. While intermediate goods are goods which are to be processed,
further into other goods. To avoid counting, only final goods and services
are counted as part of GNP. For example, a consumer buys leather, the
price paid for leather is counted as part of GNP if it will not be sold again
and it is in its final form. However, if a shoemaker uses leather to produce
a pair of shoes, leather will be counted as part of that pair of shoes. If
both the leather and the shoes were counted, the leather would be added
in twice and so exaggerate the GNP.

GNP may increase if there is an increase in (a) the prices, (b) the
quantities, or (c) both the prices and the quantities of goods and services
produced. To reflect the real output, we adjust the GNP figures by using
the consumer price index (CPI) as deflator or inflator. Adjusted or real
GNP is the money GNP divide by CPI.

Real GNP =Money GNP

CPI

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Principles Of Economics (with Taxation and Agrarian Reform)

Consumer Price Index (CPI) is a tool used to measure the

changes in the prices of the commodities.

CPI = P x 100
P

Where: P = price in a given year

P = price in a base year
Items that are not included or reflected in GNP

1. Quality of the goods and services produced

For example, the computers produced today are very much better
and advance than the computers in 1975. GNP only shows the total
value of computers produced today is greater than their total value
in 1975.

2. Leisure time

GNP does not reflect the improvements in efficiency. The workers

today produce more goods and services than the workers did it 40
years ago. Increases in efficiency have allowed people more free
time, which is not reflected in GNP.

3. Housewives’ services

The services of a housewife are free and GNP does not count those
that are given away free. GNP measures only goods and services
that command a price.

4. Resale

GNP counts only new goods produced for sale. Resold or transferred
goods are not counted because no wealth is created. Goods
produced during a specific year are counted. Those produced before
or after are not added into GNP for the year. For example, year 2002
GNP did not include goods produced in year 2001 and those in year
2003.

5. Transfer payments

Gift, grants, retirement and pension payments and others are not
included in
GNP because they do not affect the production of goods and service.

6. Security

Buying and selling of stocks and bonds do not affect the production
of goods or operation of the business. Thus, they are not counted.

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Principles Of Economics (with Taxation and Agrarian Reform)

Method used to measure GNP

1. Expenditure method or flow of product approach.

2. Income method or earnings and cost approach.
3. Industrial origin method.
4. Value added approach.

1. Expenditure Method or Flow of Production

Approach:

This method measures all the money spent on goods and

services by the following sectors:
(a) Personal consumption expenditures (C)
Spending of consumers on final goods and
services.

(b) Gross private domestic investment (Ig)

Spending of business for new capital goods
(investment)

(c) Government purchases of goods and services

(G)
Spending of all levels of government.

(d) Net exports (of goods and services) (Xn)

Net Exports are the value of the goods sold outside the
country (exports) less the value of the goods sold in the
country that are made abroad (imports).

Xn = Export – Import

GNP = C + Ig + Xn (in the case of an open

economy)

GNP = C + Ig + G (in case of a closed economy)

2. Income Method or Earnings and and cost Approach

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Principles Of Economics (with Taxation and Agrarian Reform)

This method accounts for all the money received for the
production of goods and services.

Add: Rents
Wages and salaries
Interests
Proprietor’s income
Corporate income
Indirect business taxes
Depreciation
Equals: GNP

Corporate Income = undistributed Corporate Profits

+ dividends + Corporate Income
Taxes

Industrial Origin Method

This method measures the value of the goods and

services produced by the following industries.

Industry

Add: 1. Agriculture, Fishery and

forestry---------------------------- P xxx

2. Industrial
Sector------------------------------------------------- P xxx

a. Mining and Quarrying--------------------------------

P xx
b. Manufacturing-------------------------------------------
P xx
c. Electricity, gas and water----------------------------
P xx

3. Service
Sector----------------------------------------------------- P xxx

a. Transport, communication--------------------------
P xx
and storage

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Principles Of Economics (with Taxation and Agrarian Reform)

b. Commerce----------------------------------------------
P xx
c. Services-------------------------------------------------
P xx

Equals: GROSS DOMESTIC PRODUCT (GDP)

----------------- P xxx

Less: Net factor income from the rest of the

world-------------- (P xx)

Equals: GROSS NATIONAL PRODUCT (GNP)

---------------- P xxx

Philippines use the industrial origin method to measure

GNP.

3. Value Added Method

This method measures the value of the goods and services

produced based on the value added at each stage of
production or distribution and included in the cost to the
ultimate consumer.

Value added is the difference between the cost of materials

goods and the value of the sales of goods. For example, if a firm
buys materials for P100 and produces from a product while sells for
P250, the value added by the firm is P150.

Candy Manufacturing

Sales Value of
Materials/Product Value Added

Farmer (sugar cane) P1000

P1000
Miller (sugar) 1500 500
Confectionaire (candy) 3000 1500
Retailer 5000 2000
P10,500 P5000

The value of the final good (candy) is P5000

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Principles Of Economics (with Taxation and Agrarian Reform)

Net National Product (NNP)

Net national product is gross national product less capital

consumption allowances (depreciation).

NNP = GNP – depreciation

National Income (NI)

National income is the payments of income to the factors of

production.

NI = NNP – Indirect business taxes

Personal Income (PI)

Personal income refers to payments of income to individuals

such as rents paid to the owner of the land, wages paid to the
laborers, and interests paid to the owners of capital.

PI = NI – (SSS contributions + corporate income taxes +

undistributed corporate profits) + transfer payments.

Personal Disposable Income (DI)

Personal disposable income refers to the income left after

deducting personal income taxes, which the individual has at his
disposal to spend or to save.

DI = PI – Personal income taxes

Personal Savings(S)

Personal savings refers to income not spent for consumption.

S = DI – C

Or if there is interest paid by consumers

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Principles Of Economics (with Taxation and Agrarian Reform)

S = DI – (C + interest paid by consumers

Or there is interest paid by consumers

S = DI – (C + interest paid by consumers)

Measuring Economic Success

GNP shows us the economy’s performance, whether it is growing or

shrinking, healthy or sick. When GNP increases, the economy is
expanding. When GNP decreases, the economy is contracting. GNP
can be used also to compare one country’s economy with the
economy of another and with itself over time.

54

Name:___________________________________________Score:______

Section:_______________Room:______________________Date:_____

Exercise 3.1

Fill in the blanks:

1. _______ measures the market value of all the final goods and services
produced.

2._____________________ is the study of the total performance of the

economy.

3. The_____________________method to GNP counts the money spent for

goods and services.

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Principles Of Economics (with Taxation and Agrarian Reform)

4. The _____________ method to GNP counts the money received for

productions.

5. GNP only counts the __________ goods and services.

6._______________ is the difference between the cost of materials or

product and the sale s value of goods.

7._________ is the cost of depreciation of capital assets.

8.__________________ is the other name of undistributed corporate profits.

9. Philippines uses the _____________method in the computation of GNP.

10_________________are the values of the goods sold outside the country.

Name:____________________________________________Score:_____
Section:_________________Room:_____________________Date:____

Exercise 3.2

Matching Type: Write the letter of the best alternative on the blank
provided.

TERMS:

A. Net National Product H. Real-Gross National Product

B. Indirect Business Taxes I. Net private domestic investment
C. Disposable Income J. National Income
D. Proprietors’ Income K. Per-capita Gross National Product
E. Depreciation L. Dividends
F. Corporate income M. Undistributed corporate profits
G. Net exports N. Transfer Payments

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Principles Of Economics (with Taxation and Agrarian Reform)

______1. Measures output valued at the prices prevailing at a specific

point of time.
______2. The sum of corporate income taxes, dividends and undistributed
corporate profits.

______3. Portion of corporate profits, which is included in disposable

income.

______4. The total income earned be resource suppliers.

______5. National income plus indirect business taxes.

______6. The income left after payment of personal income taxes.

______7. An allowance for capital goods consumed in the production of

this year’s output.

______8. The part of profit paid out to the stockholders or owners of the
corporations.

______9. The income of partnerships, proprietorships and cooperatives.

______10. The difference between gross private domestic investment and

depreciation.

Name: _____________________________________Score:_______

Section:___________Room:_____________________Date:_______

Exercise 3.3

Write if the item is included or reflected in GNP:

_X__if not.

______1. A 3-teaching hour decline in the length of workweek of the UE

faculty members.

______2. The services of a carpenter in repairing the roof of my house.

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Principles Of Economics (with Taxation and Agrarian Reform)

______3. Government Service Insurance System (GSIS) payments

received by a retired government employee.

______4. Interest on a Central Bank Certificate of Indebtedness

(CBCI)/bond.

______5. Monthly allowances received by the students from their parents.

______6. Wages paid to a cook in a restaurant.

______7. The market value of a homemaker’s service.

______8. John received P200,000 from selling his 3-year-old car.

______9. The income of a teacher,

_____10. I paid P120 to see a movie in SR movie house.

Name:______________________________________ Score:___________

Section:_________________Room:______________Date:_____________

Exercise 3.4

1. Compute the following price indices’ and analyze what the data
mean:

Price Price Index

Year level (year 1 = 100) Interpretation

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Principles Of Economics (with Taxation and Agrarian Reform)

1 P10.00 _________ ____________

2 9.50 _________ ____________

3 9.80 _________ ____________

4 10.25 _________ _____________

5 10.25 _________ ____________

II. Compute the following price indices and analyze what the data
mean:

Money GNP Real/adjusted GNP

Year (in billion P) Price index

1 P550 110 ________

2 600 100 ________

3 840 120 ________

(a) The base year is year_______

(b) P700 is the real GNP in year________expressed in terms of prices

paid in year_______.

Name:______________________________________Score:___________
Section:__________________Room:_____________Date:__________

Exercise 3.5

The three parts of this question represent three different problems. The
figures are billions of pesos, and they refer to a specific year an (x)
opposite each item means the value is not given.
Problem
Total of A B C

1. Wages and salaries (x) (x) 95

2. Gross investment (x) (x) (x)

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Principles Of Economics (with Taxation and Agrarian Reform)

3. Undistributed corporate profits 35 50 20

4. Transfer payments 30 50 15
5. SSS contributions 40 60 30
6. Government expenditures on
Goods and services 150 (x) (x)
7. Rents (x) 60 20
8. Depreciation 50 85 35
9. Personal savings (x) 100 (x)
10. Corporate income taxes 10 25 5
11. Personal income taxes 60 80 30
12. Corporate income (x) 100 70
13. Net investment 50 (x) (x)
14. Consumption expenditures 200
300 (x)
15. Interests (x) (x) 15
16. Indirect business taxes 60 50
40
17. Proprietors income (x) (x) 55
18. Imports 10 30 (x)
19. Exports 35 10 (x)

A. For each problem, compute GNP, NNP, NI, PI, DI, and S
B. Compute the total of the ff:
a. Dividend in problems B and C
b. Gross investment in problem A
c. Consumption expenditures in problem C
d. Net exports in problem A and B
e. Personal savings in problem A

Name:______________________________________Score:_______
Section:___________________Room:______________Date:_______

Exercise 3.6

Given P (in billions)

Net investment 50
Personal income taxes 57
Transfer payments 37
Indirect business taxes 26
Corporate income taxes 29
Consumption expenditures 235

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Principles Of Economics (with Taxation and Agrarian Reform)

Depreciation 25
Interest paid by consumers 22
Exports 33
Government purchases of goods and services 69
Undistributed corporate profits 28
SSS contributions 22
Imports 35

Compute:

A. GNP D. PI

B. NNP E. DI

C. NI F. S

NATIONAL INCOME ESTIMATION

Learning Objectives

1. Use the linear consumption model to understand consumer behavior

and explain why it best describes a consumption function.

2. Discuss the determinants of consumption and saving and give

example each.

3. Understand the concept of AC, APS, MPS and how to calculate it.

4. Define investment in economic sense and distinguish it from the

accounting concept.

5. Know the determinants of investments.

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Principles Of Economics (with Taxation and Agrarian Reform)

6. Determine the equilibrium level of output in the economy through

aggregate spending approach and saving = investment approach.

Key terms:

Consumption function marginal propensity to

consume

Consumption schedule marginal propensity to

save

Savings investment

Savings schedule aggregate demand

Average propensity to consume aggregate supply

Average propensity to save multiplier

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Principles Of Economics (with Taxation and Agrarian Reform)

CHAPTER 4

NATIONAL INCOME ESTIMATION

All market economies experience swings in business activity

whenever national income fluctuates. When it does, people cannot help
but wonder why such phenomenon occurs. What forces the drive the
economy to change? What determines the equilibrium level of income?
What factors cause such a change?

In this chapter we attempt to answer these questions by assuming a

highly simplified economy, which consists only of the households and the
business firms. From this basic model, we proceed to develop the concept
of aggregate demand, aggregate supply, and the equilibrium level of
income.

Consumption, Savings, Income

Consumption, savings and income are interrelated concepts in

macroeconomics. Consumption, which is the household spending on final
goods and services, is the main component of aggregate expenditures.
Savings is the part of disposable income not spent on consumption.
Disposable income is income available for consumption and savings. How
do these concepts relate with each other?

Economic studies show that the most significant factor affecting

Consumption and savings is income, in particular disposable income. The
higher the income, the higher is the level of consumption and vice versa.
There is a positive relationship between income and consumption.
Likewise
The higher the income, the more chances people can save. Consumption
and savings rise with disposable income.

Consumption Function

An equation showing the relationship between the level of

consumption and the level of disposable income. C = f (Y) meaning
consumption depends on income.

C=a+bY

Intercept, > 0

Slope, MPC, > 0 < 1

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Principles Of Economics (with Taxation and Agrarian Reform)

income

Ex. C =40 + 80 Y
Consumption Schedule

A schedule showing the amounts households plan to spend for

consumer goods at different levels of disposable income.

Table 4.1

Consumption Schedule

Y C
(1) (2)

P 4000 P 5000
6000 6500
8000 8000
10000 9500
12000 11000

Column (1) shows the different levels of disposable income while column
(2) represents consumption spending. Columns (1) and (2) taken together
is called the consumption schedule.
At lower levels of income P4000 and P6000 household spend a larger
proportion of their disposable income than that of a higher one and people
tend to dissave,C>Y. As income rises to P8000 they tend to break-even.
Consumption is exactly equal to disposable income, no savings/no
dissavings. At incomes P10000 and P12000 households tend to save, C <
Y. 63

12000

10000
8000

6000

4000

2000
Y
0 2000 4000 6000 8000 10000 12000

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Principles Of Economics (with Taxation and Agrarian Reform)

Fig. 4.1

Figure 4.1 illustrates the income-consumption relationship. A

reference line, 45 line, is drawn northeast from the point of origin. Any
point along the 45 line shows the exact equality between consumption
and disposable income. If a point lies above the 45 line there is a
dissaving and if below, a saving.

Saving Function

Savings is unspent income. It shows how much households plan to

hold back from consumption at different levels of income. Since
disposable income is also the basic determinant of savings, it can be
noted that savings is a function of income. Savings depend on income;
household savings increases with increases in income and falls with
decrease in income.

Table 4.2 shows the various amounts of savings that households will
undertake at different levels of income. Savings is disposable income
minus consumption.

Table 4.2

Saving Schedule

Y C S

(1) (2) (3)

P 4000 P5000 P-1000

6000 6500 -500

8000 8000 0

10000 9500 500

12000 11000 1000

Column (1) shows the levels of disposable income while column (2)
represents consumption. Column (3) savings is derived by subtracting (2)
from (1).

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Principles Of Economics (with Taxation and Agrarian Reform)

At lower levels of income households cannot afford to save.

Disposable income is insufficient to meet consumption expenditures.
Hence, savings is negative (dissaving). As income rises, there will
come a point where consumption will be equal to income. Households will
be at break-even and savings is zero. At high levels spending will be less
than income and there is savings. This table illustrates the positive
relationship between income and savings.

Fig. 4.2

Figure 4.2 shows the income-savings relationship. If a point falls

along the income (Y) axis, households are breaking even hence savings is
equal to zero. However, if a point lies above the income (Y) axis, there is
a saving, (S+) and below the income axis, dissaving (S-).

Average and Marginal Propensities

APS and APS

The fraction of total income that is consumed is the average

propensity to consume (APC). The fraction of total income that is saved is
the average propensity to save (APS). That is

APC = Consumption = C

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Principles Of Economics (with Taxation and Agrarian Reform)

Income (Y) Y

APS = Saving = S
Income Y

Therefore APC + APS = 1

Example:

Table 4.3

Propensities to Consume and Save

Y C S APC APS MPC MPS

(1) (2) (3) (4) (5) (6)
(7)

P4000 P5000 P-1000 1.25 -.25 .75

.25

6000 6500 -500 1.08 -.08 .75

.25

8000 8000 0 1 0 .75

.25

10000 9500 500 .95 .05 .75

.25

12000 11000 1000 .92 .08

.75 .25

APC = C = 5000 = 1.25, APS = s = -1000 = .25, APC + APS =1

4000 4000

To calculate APC, we use the data on income and

consumption, for example, at P4000, AP 5000 = +1.25
4000

Columns (4) and (5) shows the APC and APS at the different
levels of income.

Marginal Propensities: MPC & MPS

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Principles Of Economics (with Taxation and Agrarian Reform)

The marginal propensity to consume is the extra amount that people

consume when they receive an extra disposable income. The response of
consumption to change in income is called MPC. On the other hand,
marginal propensity to save (MPS) is the proportion or fraction of any
change in income that is saved.

MPC = change in consumption = ΔC = C2 – C1

Change in income ΔY Y2 – Y1

MPS = change in saving = ΔS = S2 – S1

Change in income ΔY Y2 – Y1

Where Δ is Greek letter “tetta” which is used to denote

“change”
For example, income rises by P2000 from P4000 to P6000 as
seen in Table 4.3 Consumption grows from P5000 to P6500, an increase of
P1500. The extra consumption is 0.75 of the extra income.

MPC = C2 - C1 = 6500 – 5000 = 1500 = 0.75

Y2 – y1 6000 – 4000 2000

MPS = S2 – S1 = -500-(1000)= -500+1000 = 500 = 0.25

Y2 – Y1 = 6000=400 2000 2000

MPC + PMS = 1

.75 + .25 = 1

Non-income Determinants of Consumption

The amount of disposable income is the central factor in

determining a household consumption and saving. However, there are
factors other than income which might influence households to consume
more or less at each position level of income and thereby shift the
location of consumption and savings schedules. These are:

1. Amount of wealth owned by households

2. Expectations of future prices and income
3. Real interest rates
4. Consumer indebtedness
5. Tax levels

SHIFTS IN CONSUMPTION AND SAVING SCHEDULES

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Principles Of Economics (with Taxation and Agrarian Reform)

C1
C0
C2

Y
.
Fig. 4.3 (a) Consumption Schedule

S2

S0

S1

Fig. 4.3 (b) Savings Schedule

If households consume more at each level of disposable income

they save less. Graphically, the movement is from C to C in Fig 4.3(a) and
S to S in 4.3(b (. On the other hand, if households consume less, they
save more. The movement is toward the opposite direction.

Investment

The second major component of aggregate expenditure is

investment. Investment refers to purchases of machinery, equipment
and tools, all construction and changes in inventories. Firms invest to
earn profits. However the level of investment rests in several factors,
namely, expected rate of return, interest rate and expectations and
business confidence. Because the determinants of investment depend on
the highly unpredictable future events, investment is said to be the most
volatile component of aggregate spending.

Table 4.4

Investment demand schedule

Rates of Expected Return and Investment

Expected rate of return (r) Vol. of 1 (Billion/yr)

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Principles Of Economics (with Taxation and Agrarian Reform)

10 P0
8 5
6 10
4 15
2 20
0 25

Table 4.4 shows the amount of investments and the expected rate
of return. Suppose no investment opportunity will yield an expected rate
of return of 10% but there are P5B worth of investment opportunities with
expected rates of return 8%. People will continue to invest until such a
time when expected rate of return of P25B will be zero.

Investment Demand Curve

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Principles Of Economics (with Taxation and Agrarian Reform)

Fig 4.4

The investment demand curve slopes downward reflecting an

Inverse relationship between the interest rate and the quantity of
investment demanded.

Aggregate Demand, Aggregate Supply, and Equilibrium

After developing the concept of consumption and investment as

tools for understanding how national output and price level is determined,
we now explore the foundation of aggregate demand. What are its
components? How do they interact with aggregate supply to determine
output and prices?

There are two approaches in the determination of equilibrium level

of employment output and income. The aggregate demand-aggregate
supply approach and savings=investment approach.

Aggregate Demand-Aggregate Supply

Aggregate demand refers to the quantity of goods and

services that consumers and firms would be willing to buy at any given
price level. It represents the total output that would be willingly bought at
each price level given the monetary and fiscal policies and other factors
affecting demand.
Aggregate supply describes what output business would be willing
to produce and sell given prices, costs, and market conditions. Aggregate
supply is a function of available inputs, technology and the price level.
The equilibrium level of income refers to that income level where
aggregate demand equals aggregate supply.

Example 1

Table 4.5

Aggregate Demand & Aggregate Supply Schedules

Aggregate SupplyC I Aggregate Demand

(Output Income) (C+1)

(1) (2) (3) (4)

P4000 P5000 P500 P5500

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Principles Of Economics (with Taxation and Agrarian Reform)

6000 6500 500 7000

8000 8000 500 8500

10000 9500 500 10000

12000 11000 500 11500

Table 4.5 shows the derivation of aggregate demand. To determine

aggregate demand simply add the values of consumption (col.2) and
planned investment (col.3). Using the above data, at income level P8, 000
below, consumption plus investment spending exceeds aggregate supply
or output. At income levels above P10, 000 , consumption (C) and
investment spending (I) is less than output. Aggregate demand (AD)=
aggregate supply (AS) at income P10,000.
Fig. 4.4

Fig 4.4
shows the

graphical presentation of the equilibrium level income. The 45 line, which

used to be the reference line, is now referred to as the aggregate supply.
It shows the exact equality between spending and the different levels of
income. Consumption line is plotted using the data from table 4.5 so with
the consumption plus investment line (C+I). The point where aggregate
demand equals aggregate supply at income P10,000 is called the
equilibrium level of income.

Savings – Investment

Savings, which is unspent income, is considered a leakage in the

circular now because if people save money, some goods remain unsold. It
lessens the money circulation. On the other hand, investment spending is
an injection of funds because it firms invest; they infuse money in the

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Principles Of Economics (with Taxation and Agrarian Reform)

circular stream. For an economy to be in equilibrium, the amount saved

must be offset by an equal amount of investment.

Example 2

Table 4.6

Savings – Investment Schedules

Aggregate Supply C S I Aggregate Demand

(Output/Income)

(1) (2) (3) (4) (5)

P4000 P 5000 P-1000 P500

P5500

6000 6500 -500 500

7000

8000 8000 0 500

8500

10000 9500 500 500

10000

12000 11000 1000 500

11500

Table 4.6 shows the planned level of savings and the planned level of
investment. Recall that Y = C=S. To determine savings (col.3), simply
subtract column (2) from column (1) S=Y-C. Note that the level of
investment spending is constant at P500. This is the autonomous
investment. It doesn’t change the level of income.

Table 4.5

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Multiplier Effect

The multiplier effect shows the number of times in which the

ultimate increase in income exceeds the initial increase in investment
spending. It is also the reciprocal of MPS.

K= 1 = 1 = Y , since S=I, Ke = Y
1-MPC MPS S I

Example 3: Assume that consumption spending is represented by

the equation C=40+80Y. Recall that C+a+b Y where b represents MPC.
To compute for Ke:

Ke = 1 Ke = 1
1 – MPC MPS

= 1 = 1
1-.80 .20
= 1 = 5
.20

= 5

There is a multiplier effect because consumption depends upon the

level of disposable income. The value of the multiplier increases with

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Principles Of Economics (with Taxation and Agrarian Reform)

increases in MPC and falls as MPC falls. Hence a positive relationship

exists.

The Keynesian multiplier model would help us understand why

changes in consumption as well as investment spending determine
movements in national output, prices and employment.

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