WEEK 1

INTRODUCTIONS IN ECONOMICS

INTRODUCTION IN ECONOMICS
Economics is a social science that focuses on the production, distribution, and
consumption of goods and services and analyzes the choices that individuals,
businesses, governments, and nations make to allocate resources.

KEY TAKEAWAYS:
● Economics is the study of how people allocate scarce resources for
production, distribution, and consumption, both individually and collectively.
● The two branches of economics are microeconomics and macroeconomics.
● Economics focuses on efficiency in production and exchange.
● Gross Domestic Product (GDP) and the Consumer Price Index (CPI) are
widely used economic indicators.

Economics is the study of how societies divide and use their resources to produce
goods and services and of how those goods and services are then distributed and
consumed.

Resources are the basic ingredients that are needed to produce the goods and
services that people buy. These ingredients can be physical things such as land and
factory equipment, and they can be intangible things such as the intellectual and
emotional capacities of people, whose work is necessary for the production of goods
and services.

Whether a society is rich or poor, large or small, resources are, from the viewpoint of
economics, scarce.

This means that almost everyone in every country would like more goods and
services than can ever be produced. Given a limited supply of resources and an
unlimited desire on the part of individual consumers and nations, choices must be
made about what goods and services to produce, how to produce them, and for
whom.
BASIC TERMS OF ECONOMICS

● CAPITAL GOODS - items a business uses to produce goods or services to

sell to consumers; examples include manufacturing equipment and business
facilities
● COMMODITIES - raw material (like crude oil or iron ore) or agricultural
product (like unprocessed wheat or corn) purchased in enormous quantities
for production purposes
● CONSUMER - anyone (person or business) that uses (consumes) goods or
services
● DEMAND - the extent to which there is a market for goods or services; when
a lot of people want to buy something, the demand is high
● ELASTICITY -how much an economic variable changes in response to
another; if demand spikes when prices are low but contract when prices are
high, that is elastic demand
● EQUITY - the amount of ownership in an asset; the equity a person has in
their home is the difference between the property’s value and the amount
owed on the mortgage
● LEVERAGE - the extent to which an investment is funded with borrowed
money (debt); the investor is relying on earning a return in order to pay off the
debt and still make a profit
● LIQUIDITY - the extent to which assets could quickly be converted to cash;
for example, a checking account is more liquid than a one-year certificate of
deposit
● MARKET - any means that buyers and sellers use to exchange money for
goods or services
● SCARCITY - resources or products that aren’t available in unlimited quantities
are scarce; as scarcity of an item increases, so do prices
● SHIFT IN DEMAND - when the demand for a product or service goes up or
down due to factors other than a change in price
● SUPPLY - how much is available of a particular good or service; when supply
of a product goes down, the item becomes scarce
BASIC PROBLEM OF ECONOMICS

Production, Distribution, and Exchange of goods and services are among the basic
economic activities of life. During the period of these economic activities, every
society has to suffer from scarcity of resources and it is the scarcity of resources that
arises the problem of choice. The scarce resource of an economy has several
usages. In other words, every society decides how to use scarce resources
optimally? The problems of an economy are often summarized in the following three
ways:

● What to produce and in what quantity?

● How to produce?
● For whom to produce?

These are known as central problems because every society has to face them and
look for its solutions. Let us understand these three central problems in detail.

1. What to Produce

This problem refers to the decisions regarding the selection of different commodities
and the quantities that need to be produced. Labour, land, machines, capital,
equipment, tools and natural resources are limited. So, it is not possible to fulfil
society’s every demand. Therefore, it is important to decide what goods and services
are required to be produced and in what quantity?

For example, if Rita has a piece of land, she needs to think about what crop she
should produce on her land. Let us consider that she can grow either Jowar or
wheat. Given that the natural resource i.e. land is limited, she needs to choose
whether she wants to use the land to produce Jowar or wheat or both. Once Rita has
taken the decision regarding the goods to be produced, she needs to think about the
quantity of the crop that she would like to produce.

For example, 5 quintals, 10 quintals, or 100 quintals. This problem of ‘what to

produce and in what quantities to produce is almost faced by everyone in society.
Also, an economy needs to make decisions regarding whether it wants to use its
scarce resources to produce consumer goods or producer goods. Also, to what
extent should luxury goods be produced in comparison to producer goods? Also, the
economy may be faced with the question of how many civilian goods and defense
goods need to be produced. The problem of what to produce and in what quantities
to be produced can be solved by a government that retains the authority to allocate
resources in different areas of production. Alternatively, it can be solved based on
the preferences of people in an economy and on the price of goods and services
available in the market.

2. How to Produce?

This problem is about the choice of techniques that need to be adopted and used in
the production of goods and services. The two majorly-used techniques are-

LIT or Labor Intensive Techniques

In this technique more units of labor in proportion to capital are used in the
production process.

Capital Intensive Techniques

On the other hand, the Capital Intensive Technique involves more capital and less
utilization of labor. For instance, footwear can be manufactured either in factories
where a large portion of manufacturing is carried out by machines or by skilled teams
of cobblers.

The solution to the problem of how to produce is based on the amount of quantity
that needs to be produced for a given level of resources. At the same time, the cost
of using a technique to produce goods is equally very important. A producer will use
that particular technology which is available at minimum cost.

3. For Whom to Produce?

One of the most crucial problems of the economy is to decide which commodities
shall be produced for which sections of society. For instance, essential goods and
services are in demand from all sections of society, but only certain sections of
society have a demand for luxury commodities. At the same time, choices of goods
and services rest on prevalent tastes and preferences in an economy. Hence,
considerations regarding the socio-economic conditions of a country or market are
highly pertinent to this problem.

Lastly, it is important to know that other than resource allocation, central problems of
an economy have two more aspects – efficient utilization of the resource and
development of resources. Thus, to explain the central problems of an economy, one
needs to delve into its core, i.e. choices concerning the limited resources available to
maximize socio-economic utility.

PRINCIPLES OF ECONOMICS
1st H’s: Principle of Economics
● How people makes decisions
1. People face trade-offs
- Trade-off are the things you got after giving up the opportunity cost
- People pays off are trade off
2. The cost of something is what you give up to get it
- Opportunity Costs are the things that you gave up for another
opportunity
3. Rational people think at the margin
- Marginal Benefits are your benefits
4. People respond to incentives

2nd H: Principles of Economics

● How People Interact
5. Trade can make Everyone Better Off
- Early evidence is Barter system
- Actions happening inside a market is an economic activity
6. Markets are usually a Good Way to Organize Economic Activity
- Markets organize economic activity as it determine the demand and
supply of the good
- It is stated that a market with little to no interference by the government
is good, however, having no interference is bad as it isn’t controlled.
7. Government Can Sometimes Improve Market Outcomes
- Government can Promote Products through trades
 - Government can put up price ceiling and price floors to control the
market
- Government can control the monetary policies through the Center Bank
of the Philippines
- Government can also protect intellectual rights
- Government prevents monopoly

3rd H’s: Principles of Economics

● How the Whole Economy Works?
8. A Country’s Standard of Living Depends on the Ability to Produce and
Services
9. Prices Rise when the Government Prints Too much money
10. Society Faces a Short-Run Trade-Off between Inflation and Unemployment

OPPORTUNITY COST
The opportunity cost of an item is what you give up to get that item or The cost of
something is what you give up to get it. When making any decision, decision makers
should take into account the opportunity costs of each possible action. In fact, they
usually do.

EXAMPLE:

If you spend time and money going to a movie, you cannot spend that time at
home reading a book, and you can’t spend the money on something else. If your
next-best alternative to seeing the movie is reading the book, then the opportunity
cost of seeing the movie is the money spent plus the pleasure you forgot by not
reading the book.

The opportunity cost measures the trade-off between the two goods that each
producer faces.

Formula and Calculation of Opportunity Cost

The opportunity cost equation is an important tool for those who wish to make
well-informed decisions. Essentially, the equation involves calculating the returns of
various investment choices and thereby determining what will be lost by missing out
by choosing one alternative over others. The following opportunity cost formula
shows how to calculate opportunity cost:

Opportunity Cost = Return on Most Profitable Investment Choice - Return on

Investment Chosen to Pursue

EXAMPLE
When Not to Use Opportunity Cost?
The concept of opportunity cost does not always work, since it can be too
difficult to make a quantitative comparison of two alternatives. It works best when
there is a common unit of measure, such as money spent or time used.
Opportunity cost is not an accounting concept, and so does not appear in the
financial records of an entity. It is strictly a financial analysis concept.

Opportunity Cost vs. Sunk Cost

There are significant differences between opportunity costs and sunk costs. A sunk
cost is a cost that has already been paid for, whereas an opportunity cost is a
prospective return that has not yet been earned. Thus, a sunk cost is backward
looking, while an opportunity cost is forward looking.

A sunk cost cannot be recovered and an opportunity cost cannot be obtained.

Given sunk costs have already occurred, the cost will remain the same regardless of
the outcome of a decision

Ex: Your business has spent $2 million building a state-of-the-art printer. Your buyers
then decide they want to stop printing and publish their content online only. Your
company must consider the relevant costs. They can either decide to finish building
the printer which would cost another $1 million, or they could decide to build out their
online publication system for $2 million.
FACTORS OF PRODUCTION / ECONOMIC
RESOURCES AND ITS ECONOMIC PAYMENT
The factors of production are land, labour, capital and entrepreneurship.

Land
- Is a vital factor needed for producing raw materials/Rent.
- the primary factor of production
- includes any natural resource used to produce goods and services; anything
that comes from the land.
- Its payment is rent/ For the benefits that the land offers, rent is paid.

Examples: water, oil, copper, natural gas, coal, and forests.

Labor
- Is manpower resources needed to transform raw materials into finished
product
- Human Resources
- Is human physical and mental ability employed in the generation of goods and
services
 - Its payment is wage/ Wages are used as the means of payment.

Examples: service crew, construction worker

Capital
- secondary factor of production as it can be manipulated by economic activity.
- In economics, capital typically refers to money.
- is the primary driver of value, because money is not used directly in the
creation of a thing or service, it is not a factor in production. Instead, it makes
it possible for business owners and entrepreneurs to buy equipment, pay for
real estate, or pay employees, which simplifies the production processes.
- Its payment is interest/ Interest would be received as payment.

Examples: buying machineries, paying an employee, buying furnitures

Entrepreneurship
- Special skills of individual
- A Combination of the other three factors - land, labor and capital
- The entrepreneur is the one who starts the production process by enlisting the
other production factors.
- Its payment is profit/ The business owner earns profit from it.

Examples: Businessman, Owner

ECONOMIC ACTIVITY
Economic Activity

● Have you ever worked a job? Bought a hamburger? Purchased a video game at a
local game store? If so, you've participated in what the business community calls
economic activities.
● “The activity of making, purchasing, or selling goods or services.”
● Economic activities include consuming goods and services that involve an exchange
of money.
● These are the steps related to the consumption of goods and services and
activities in which money is exchanged for a product or service.
● Economic activities are present in almost every aspect of our society. The easiest
way to explain this is that all activities that involve money or the exchange of
products are considered economic activities.
● It is performed for the purpose of:
a. making money
b. gaining wealth
c. creating and producing items that can be offered to the public for sale

Common Examples:

● running a small business is a great example of economic activity

● employees working in a factory and receiving wages are performing economic
activities.
● Employers are also economically active because they pay the workers and
make and sell goods.
Three Types of Economic Activities

1. Business - this economic activity provides goods and services to satisfy human
needs on a daily basis with the aim of earning profits.
2. Profession - it can also be defined as an occupation or a professional job that offers
specialized services in return for professional charges.
3. Employment - This activity is based on a contract between the company and the
employee. Here, the employee performs duties for the company, and is paid (with
wages or a salary) in return.

https://byjus.com/commerce/meaning-of-economic-and-non-economic-activities/

Economic activities are mostly divided into four large types:

Primary Activities

● referring to the activities that deal with the acquiring of natural resources
directly from nature
● Activities that are mostly outdoor in nature. This is why the people that are
engaged in these activities are often called red-collar workers.
● e.g., gathering, farming, hunting, fishing, forestry, etc.

Secondary Activities

● it includes the process of adding value to products by modifying them.

● These activities take existing products and change them in multiple ways, which
adds extra value to them.
● They include mostly manufacturing industries, anything that gets created in
factories, from processed foods to clothes, belongs here.
● The name we use to describe the workers in the fields of secondary economic
activities is blue-collar workers.

Tertiary Activities
 ● Providing various kinds of service. Anything ranging from clerks and barbers to
auto mechanics falls into this group.
● most easily defined as “personal and business services”
● Involve experts in specific fields that fall outside what is considered common
knowledge. Workers here are called pink-collar workers.

Quarternary Activities

● includes all of those that are provided in a special environment.

● A good example would be health services, which we can only get in hospitals.
● Other examples include hotels which provide us with hospitality services or schools
which provide us with teaching services.
● For example, theatres fall under quaternary activities because they provide
entertainment services.
● We call the workers that are engaged in quaternary activities white-collar workers.

https://www.worldatlas.com/articles/what-are-the-4-types-of-economic-activity.htm

Non-Economic Activity
● an activity performed with the purpose of rendering services to others without any
considerations of financial gains.

Common Examples:
1. Free time activities – They aim to acquire pleasure during idle times. (Painting,
singing, etc.)
2. Family commitment activities – These activities are dedicated and inspired by the
institution of family. (a teacher offering education to own child at home, a doctor
consulting a patient in his family, etc.)
3. Cultural and religious activities – These activities include the ideas of happiness and
mental satisfaction. (Worshipping God, visiting the temple, etc.)
4. Social welfare activities – They are based on the passion for helping or sympathising
towards others in the society. (Donations to the underprivileged, participation in relief
camps to help the people affected by war, etc.)

The Circular Flow of Economic Activity

● A model showing the basic economic relationships within a market economy.

● The circular flow model shows where money goes and what it's exchanged for.
The model includes households, businesses and governments. We also have a
 banking system that facilitates the exchange of money and helps to productively turn
savings into investment in order to grow the economy.
● In the circular flow of the economy, money is used to purchase goods and services.
Goods and services flow through the economy in one direction while money
flows in the opposite direction.

● The factors of production include land, labor, capital and entrepreneurship. The
prices that correspond to these factors of production are rent, wages and profit.
● People in households buy goods and services from businesses in an attempt to
satisfy their unlimited needs and wants.
● Households also sell their labour, land, and capital in exchange for income that they
use to buy goods and services that firms produce.
● Businesses sell goods and services to households, earning revenue and generating
profits. Businesses also pay wages, interest and profits to households in return for
the use of their factors of production.
● Governments levy taxes on households and businesses in order to provide certain
benefits to everyone.

https://study.com/academy/lesson/circular-flow-of-economic-activity-the-flow-of-goods-servic
es-resources.html
DEMAND AND SUPPLY
Demand - refers to the amount of goods or services desired by the consumers in a
specific time period.

Quantity Demanded - amount of goods and services that people are willing to buy at a
given place, time, and price.

Law of Demand - price up, quantity demanded down || price down, quantity demanded up
- Inverse relationship (negative)

Determinants of Demand
1. Consumer’s income
a. Normal Good - demand increases when income increases and vice versa.
[Example: rice, electricity, water, etc.]
b. Inferior good - demand falls when income increases and vice versa [Example:
transportation, fast food]

2. Consumer’s Expectations of Future Prices - expecting price increase causes panic

buying
3. Prices of related products - demand for any related good will be affected if the price of
other related good increases [Example: price of soda increases because the price of sugar is
high]

4. Consumer taste and preference - own preference regarding product

5. Population - the more people there is, the more goods and services are being consumed

Supply - the maximum quantity of goods and services that producers can offer
Quantity Supplied - amount of goods and services that producers are willing to
supply at a given time, place, and price
Law of Supply - price up, quantity supplied up || price down, quantity supplied down

Determinants of Supply
1. Change in technology - advanced technology enables producers to
supply goods faster
2. Cost of inputs used - high cost of materials = high price of goods
3. Expectation of future prices - enables the pricing of certain goods
4. Price of related goods - same as above
5. Government regulations and taxes -
6. Government subsidies -
7. Number of firms in the market - morer competition means more supply of
goods there is
DEMAND SCHEDULE, SUPPLY SCHEDULE,
EQUILIBRIUM, SHORTAGE SUPPLY

Demand Schedule - It demonstrates how consumers have diverse needs at various

pricing levels. A demand schedule can be graphed as a continuous demand curve
on a chart where the Y-axis represents price and the X-axis represents quantity.
- a table that shows the quantity demanded of a good or service at different
price levels.

Supply Schedule - which depicts the quantity of an item that would be provided to
the market by producers at specific price levels, is usually combined with a demand
schedule.
- a table that shows the quantity supplied at each price

Equilibrium - happens when by all economic forces are balanced. Without any
outside effects, economic variables remain at their equilibrium values.
How are they connected?
- In a typical supply and demand relationship, the amount demanded tends to
decrease as the price of an item or service increases. The market reaches
equilibrium where the supply and demand schedules meet if all other
variables are equal. At this time, the corresponding amount is the equilibrium
quantity traded in the market, and the corresponding price is the

market price.

Shortage - a condition where quantity demanded is higher than quantity supplied

Surplus - quantity supplied is more than quantity demanded

FACTORS AFFECTING DEMAND & SUPPLY
Factors Affecting Demand

1. Price of the Product

● The Law of Demand states that there is an inverse (negative) relationship between
the price of a product and the amount of that product consumers are willing and able
to buy.
● Consumers want to buy more of a product at a low price and less of a product at a
high price.

2. The Consumer's Income

● The effect that income has on the amount of a product that consumers are willing
and able to buy depends on the type of goods we're talking about.

2 Types of Goods
a) Normal Goods
- There is a positive (direct) relationship between a consumer's income
and the amount of the good that one is willing and able to buy.
- For these goods when income rises the demand for the product will
increase; when income falls, the demand for the product will decrease.
b) Inferior Goods
- For some goods the effect of a change in income is the reverse.
- For example, as a student with a budgeted allowance, you might opt
to eat at karinderyas to save money. However, if your income
increases enough, you might decide to stop eating at karinderyas and
decide to eat at fast foods or restaurants. If this is the case, we might
refer to karinderyas as inferior goods.
- Remember: Inferior goods are not necessarily low-quality goods. This
just means that there is an inverse (negative) relationship between
one's income and the demand for that good. Also, whether a good is
normal or inferior may be different from person to person. A product
may be a normal good for you, but an inferior good for another person.

3. The Price of Related Goods

● As with income, the effect that this has on the amount that one is willing and able to
buy depends on the type of goods we're talking about.
● For example: Two complement goods that are typically consumed together are
bagels and cream cheese. If the price of a bagel goes up, the Law of Demand tells
us that we will be willing/able to buy fewer bagels. But if we want fewer bagels, we
will also want to use less cream cheese (since we typically use them together).
Therefore, an increase in the price of bagels means we want to purchase less cream
cheese.
● When two goods are complements, there is an inverse relationship between the price
of one good and the demand for the other good.
● On the other hand, some goods are considered to be substitutes for one another: you
don't consume both of them together, but instead choose to consume one or the
other.
● For example, for some people Coke and Pepsi are substitutes (as with inferior goods,
what is a substitute good for one person may not be a substitute for another person).
If the price of Coke increases, this may make Pepsi relatively more attractive. The
Law of Demand tells us that fewer people will buy Coke; some of these people may
decide to switch to Pepsi instead, therefore increasing the amount of Pepsi that
people are willing and able to buy.
● When two goods are substitutes, there is a positive relationship between the price of
one good and the demand for the other good.

4. The Tastes and Preferences of Consumers

● This is a less tangible item that still can have a big impact on demand.
● There are all kinds of things that can change one's tastes or preferences that cause
people to want to buy more or less of a product.
● Examples:
1. If your favorite influencer promoted a specific product, this may increase the
demand for that product.
2. However, if a new health study comes out saying something is bad for your
health, this may decrease the demand for the product.
3. Another example is that a person may have a higher demand for an umbrella
on a rainy day than on a sunny day.

5. The Consumer's Expectations

● It doesn't just matter what is currently going on - one's expectations for the future can
also affect how much of a product one is willing and able to buy.
● For example, if you expect the price of gasoline to go up tomorrow, you may fill up
your car with gas now. So your demand for gas today increased because of what you
expect to happen tomorrow.
6. The Number of Consumers in the Market
● As more or fewer consumers enter the market this has a direct effect on the amount
of a product that consumers (in general) are willing and able to buy.
● For example, a pizza shop located near a University will have more demand and thus
higher sales during the fall and spring semesters. In the summers, when fewer
students are taking classes, the demand for their product will decrease because the
number of consumers in the area has significantly decreased.
FACTORS AFFECTING SUPPLY

1. Price of Inputs
● In addition to the price of the product being the main factor as stated in the Law of
Supply, the price of production inputs also plays a part.
● The lowest price at which a firm can sell a good without losing money is the amount
of money that it costs to produce it. Producing a good or service involves taking
inputs and applying a process to them to produce an output.
● The output is the finished goods or services, and inputs are raw materials, labor,
utilities, licensing fees, or even other goods. These inputs are also known as factors
of production.
● If the price of inputs goes up, the cost of producing the goods increases. And
therefore at each price producers need to sell their goods for more money. So an
increase in the price of inputs leads to a decrease in supply. Similarly, a decrease in
the price of inputs leads to an increase in supply.
- If the price of wheat rises, for example, farmers will cultivate more wheat rather than
rice. This might reduce the amount of rice available on the market. Overall, pricing is
the most important element affecting a product's availability.

2. Cost of Production
● The cost of manufacturing and the supply of a commodity are diametrically opposed.
If the cost of production rises, corporations will reduce their product supply in order to
save money.
● For example, the cost of manufacturing has increased owing to high labour wages,
adverse natural circumstances such as crop failure, as well as increases in raw
material prices, taxes, transportation costs, and so on.
● In this instance, the company's managers would either offer a reduced quantity of
goods to the market or keep the commodity on hand until the market price is
surpassed.

3. Natural Conditions:
● It implies that weather conditions have a direct impact on the availability of particular
goods. When the monsoon arrives on schedule, for example, the quantity of
agricultural goods increases.
● During droughts, however, the availability of these goods declines. Some crops are
climate-sensitive, and their growth is solely dependent on weather conditions.
● Kharif crops, for example, are best cultivated in the summer, whereas Rabi crops are
best grown in the winter.
4. Technological advancements
● One of the most critical supply factors.
● A better and more modern technology enhances a product's production, resulting in
an increase in the product's supply.
● Example: The manufacturing of fertilisers and high-quality seeds boosts agricultural
productivity. This boosts the market's supply of food grains even further.

5. Transport Conditions
● Improved transportation infrastructure boosts product supply. Transport is always a
stumbling block to product supply, since items are not delivered on time owing to
insufficient transportation infrastructure. As a result, even if the price of a product
rises, the supply does not.
● In India, vendors often employ road transport, which is difficult to arrive on time due
to poor road maintenance. Products that are created in one section of the city must
be distributed throughout the country by road transport.
● This may cause the majority of the items to be damaged throughout the travel,
resulting in a significant loss for the vendor. Furthermore, due to the delay in product
delivery, the vendor may lose consumers.

6. Factor Prices and their Availability

● One of the most important factors of supply. Factors are the inputs necessary at the
moment of manufacturing, such as raw materials, labour, equipment, and
machineries.
● There would be an increase in output if the factors were accessible in adequate
quantity and at a reduced price. This would boost a product's supply on the market.
● Example: Having access to low-cost labour and raw materials near a company's
production site may assist cut labour and transportation expenses. As a result, the
product's production and supply would grow.

7. Government Taxation Policy:

● Changes in taxation have an inverse effect on the supply of a product. The profit
margin of the product narrows when the government raises taxes. As a result, the
producer's supply is reduced.
● Tax breaks and subsidies, on the other hand, are commonly utilised by the
government to enhance the supply of specific items by ensuring a higher profit
margin for the providers.

8. Related Goods Prices

● The reality that the pricing of replacements and complementary items have an impact
on a product's supply.
● Example: If the price of wheat rises, farmers will cultivate more wheat than is
required. This would reduce the amount of rice available on the market.

9. Calamities
● Natural disasters such as war or starvation must have an impact on the supply of
products.
● We are all too familiar with commodity shortages caused by conflict and production
disruptions induced by hunger. Even at higher costs, sufficient supplies are not
available.

10. The firm's goals and objectives

● In general, a commodity's supply grows exclusively at higher prices because it
achieves the profit maximisation goal.
● With the shift in the market, some companies are eager to supply more even at rates
that do not maximise their earnings. The goal of such businesses is to expand their
market share and improve their status and reputation
MATHEMATICAL FUNCTION
GROSS DOMESTIC PRODUCT (GDP)

Gross Domestic Product (GDP)

Measure of the total income of everyone in the economy and the total expenditure on the
economy’s output of goods and services.

“For an economy as a whole, income must equal expenditure”

Definition of GDP as a measure of total expenditure

The market value of all final goods and services produced within a country in a given
period of time.

Components of GDP

Y = C + I + G + NX

Gross Domestic Product is denoted as Y

The Gross Domestic Product is divided into four components:

C = Consumption
I = Investment
G = Government Purchases
NX = Net Exports

Consumption
Spending of households on goods and services, with the exception of purchases of new
housing. Goods include durable goods (automobiles and appliances) and nondurable
goods (food and clothing). Services include intangible items (haircuts and medical care).

Investment
The purchase of capital goods that will be used in the future to produce more goods and
services. Investment is the sum of purchases of business capital, residential capital,
and inventories. Business investment Includes business structures, equipment, and
intellectual property products. Residential capital includes the landlord’s apartment building
and a homeowner’s personal residence.

Note: In GDP, investment refers to the purchase of goods that will be used to produce other
goods and services.
Government Purchases
Measure of spending goods and services by local, state, and federal governments.
Includes the salaries of government workers as well as expenditures on public works.

Net Exports
Spending on domestically produced goods by foreigners (exports) minus spending
on foreign goods by domestic residents (imports). The net in net exports refers to the
fact that imports are subtracted from exports. This is made because other components of the
GDP include imports of goods and services.

Real GDP and Nominal GDP

If total spending rises from one year to the next, at least one of two things must be true: (1)
the economy is producing a larger output of goods and services, or (2) goods and services
are being sold at a higher price.

Economists use Real GDP to answer the question: What would be the value of the goods
and services produced this year if valued using the prices that prevailed in some specific
year in the past.

Nominal GDP - production of goods and services valued at current prices

Real GDP - production of goods and services valued at constant prices

Price changes do not affect real GDP, changes in real GDP reflect only changes in quantities
produced. Thus, real GDP measures the economy’s production of goods and services. Real
GDP is a better gauge of economic well-being than nominal GDP. When economists talk
about growth in the economy, they measure that growth as the percentage change in real
GDP from one period to another.

GDP Deflator
Measures the current level of prices relative to the level of prices in the base year. If
both nominal and real GDP rise at the same rate, the GDP deflator is constant. If the
nominal GDP rises but real GDP remains the same, the GDP deflator rises.

Formula for GDP Deflator:

Inflation
Describes a situation in which the economy’s overall price level is rising. The inflation
rate is the percentage change in some measure of price level from one period to the
next. Using the GDP deflator, the inflation rate between two consecutive years is computed
as follows:
 CONSUMER PRICE INDEX (CPI)
The Consumer Price Index (CPI)
A measure of the overall cost of the goods and services bought by a typical consumer

How to Compute for CPI

1. Fix the basket - Determine which prices are most important to the typical consumer.
For example, if the typical consumer buys more hot dogs than hamburgers, then the
price of hot dogs is more important than the price of hamburgers, therefore having a
greater weight in measuring the cost of living.
2. Find the price - Find the prices of each of the goods and services in the basket at
each point in time.
3. Compute the basket’s cost - Use the data on prices to calculate the cost of the
basket of goods and services at different times.
4. Choose a base year and compute the index - Designate one year as the base
year, the benchmark against which other years are to be compared. Once the base
year is chosen, the index is calculated as follows:

5. Compute the inflation rate - Use the CPI to calculate the inflation rate, which is the
percentage change in the price index from the preceding period. That is, the
inflation rate between two consecutive years is computed as follows:
In addition to the CPI for the overall economy, the BLS calculates several other price
indexes. It reports the index for some narrow categories of goods and services, such as
food, clothing, and energy. It also calculates the CPI for all goods and services excluding
food and energy, a statistic called the core CPI. The core CPI better reflects underlying
inflation trends because food and energy prices show substantial short-run volatility. The
BLS also calculates the producer price index (PPI), which measures the cost of a basket
of goods and services bought by firms rather than consumers. PPI is often thought to
be useful for predicting changes in the CPI because firms eventually pass on their costs to
consumers in the form of higher consumer prices.

CORRECTING ECONOMIC VARIABLES FOR THE EFFECTS

OF INFLATION

Dollar Figures from a Different Time

The formula for turning dollar figures from a specific year into today’s dollars is the following
For example: An American man’s salary in 1931 was $80,000. The CPI in 2018 is 251
compared to 1931’s CPI 15.2. We can measure the 1931’s salary in 2018 as follows:

Indexation - the automatic correction by law or contract of a dollar amount for the effects of
inflation

Real and Nominal Interest Rates

Nominal Interest Rates - the interest rate as usually reported without a correction for the
effects of inflation
Real Interest Rates - the interest rate corrected for the effects of inflation

OTHER MACROECONOMICS FORMULAS

OTHER MICROECONOMICS FORMULAS
 ECONOMIC MODELS
An economic model is a simplified description of reality, designed to yield hypotheses about
economic behavior that can be tested. An important feature of an economic model is that it is
necessarily subjective in design because there are no objective measures of economic
outcomes. Different economists will make different judgments about what is needed to
explain their interpretations of reality.

● Economic models generally consist of a set of mathematical equations that describe

a theory of economic behavior. The aim of model builders is to include enough
equations to provide useful clues about how rational agents behave or how an
economy works.
● Economic models can be quite simple in practice: the demand for apples, for
example, is inversely related to price if all other influences remain constant. The less
expensive the apples, the more are demanded.
● Economic models can also be classified in terms of the regularities they are designed
to explain or the questions they seek to answer.
● Other models are designed to focus on structural issues, such as the impact of trade
reforms on long-term production levels, ignoring short-term oscillations.
● Economists also build models to study “what if” scenarios, such as the impact on the
overall economy of introducing a tax added in a product

2 economic model

THE CIRCULAR FLOW

This model is a Schematic
Representation of the organization of the
economy. Decisions are made by the
households and firms. Households and
firms interact in the markets for goods
and services (wherein household are
buyers and firms are the sellers). The
outer set of arrow shows the
corresponding flow of the inputs and
outputs in every part of the flow.
The economy is simplified to include only two types of decisions markers (which is the firm
and households). Firms produce goods and services using inputs such as labor, land and
capital (ex. Buildings and machines). These factors are called factors of production. The
circular flow diagram offers a simple way to organize the economic transaction that occur
between the household and firms. household owns the factors of production and consume
all the goods and services that the firm produce.

Parts of circular flow

Household- owns the factor of production and consume all the goods and services that the
firm produce. It interacts with two types of markets.

Markets for goods and services- households are buyers. And firms are sellers. The
household buys the output of goods and services that firms produce.

Market for factors of production- households are seller and the firms are the buyers.
Household provides and make the inputs that firms use to produce goods and services.

The inner loop - this represents the flows of inputs and outputs. The households sell the
use of their labor, land, and capital to the firms in the markets for the factors of production.
The firms then use these factors to produce goods and services, which in turn are sold to
households in the markets for goods and services (this includes the local trade of goods and
services we have in the market)

The outer loop- this represents the corresponding flow of dollars. The households spend
money to buy goods and services from the firms. The firms use some of the revenue from
these sales to pay for the factors of production, such as the wages of their workers. (This
flow includes the international trade of services and goods that occurs in the market)

The Production Possibilities Frontier

This model is a graph that shows the various combination output. In this case all the output,
goods and services that the economy can possibly produce given the available factors of
production and production technology that firms use to turn these factors into output. This
shows the combinations of output that the economy can possibly produce given the available
factors of production and the available production technology

➔ The production possibilities frontier shows one trade-off that society faces.
➔ The production possibilities frontier shows the trade-off between the outputs of
different goods at a given time, but the trade-off can change over time
 This model shows this economy’s production
possibilities frontier. If the economy uses all its
resources in the car industry, it produces 1,000
cars and no computers. If it uses all its
resources in the computer industry, it produces
3,000 computers and no cars. The two
endpoints of the production possibilities frontier
represent these extreme possibilities.

More likely, the economy divides its resources

between the two industries, producing some
cars and some computers. For example, it can
produce 600 cars and 2,200 computers, as
shown in Figure 2 by point A. Or, by moving
some of the fac-tors of production to the car
industry from the computer industry, the
economy can produce 700 cars and 2,000
computers, represented by point B.

I. The production possibilities frontier shows the combinations of output. in this case,
cars and computers that the economy can possibly produce. The economy can
produce any combination on or inside the frontier. Points outside the frontier are not
feasible given the economy’s resources. The slope of the production possibilities
frontier measures the opportunity cost of a car in terms of computers. This
opportunity cost varies, depending on how much of the two goods the economy is
producing.
II. Most likely the economy divides its resources between the two industries. It is
because resources are scarce, not every conceivable outcome is feasible. (no matter
how resources are allocated between the two industries, the economy cannot
produce that much amount. Given the materials and technology that is given. The
economy does not have enough factors of production to support that level of output.
With the resources it has. It cannot produce at points outside the frontier.

Outcome- is said to be efficient if the economy is getting all it can from the scarce resources
it has available. It points on the production possibilities frontier represent efficient levels of
production.
A Shift in the Production Possibilities Frontier

hu
A technological advance in the computer
industry enables the economy to produce
more computers for any given number of
cars. As a result, the production possibilities
frontier shifts outward. If the economy
moves from point A to point G, then the
production of both cars and computers
increases

In this figure it shows what will happen

when an economy grows. Society can move
production from a point on the old frontier to
a point on the new frontier. Which point it
chooses depends on its preferences for the
two goods.

The production possibilities frontier simplifies a complex economy to highlight some basic
but powerful ideas: scarcity, efficiency, trade-offs, opportunity cost, and economic growth. As
you study economics, these ideas will recur in various forms. The production possibilities
frontier offers one simple way of thinking about them

NORMATIVE - BASED ON OPINION

POSITIVE - FACTUAL