CORPORATE GOVERNANCE

ROLE OF BOARD OF DIRECTORS

•A corporation is a mechanism established to allow different parties to contribute capital, expertise, and labor for
their mutual benefit.
• The term corporate governance refers to the relationship among these three groups in determining the direction
and performance of the corporation.
RESPONSIBILITIES OF THE BOARD
• 1. Effective board leadership including the processes, makeup, and output of the board
• 2. Strategy of the organization
• 3. Risk vs. initiative and the overall risk profile of the organization
• 4. Succession planning for the board and top management team
• 5. Sustainability
ROLE OF THE BOARD IN STRATEGIC MANAGEMENT
•■ Monitor: By acting through its committees, a board can keep abreast of developments inside and outside the
corporation, bringing to management’s attention developments it might have overlooked.
•■ Evaluate and influence: A board can examine management’s proposals, decisions, and actions; agree or
disagree with them; give advice and offer suggestions; and outline alternatives.
•■ Initiate and determine: A board can delineate a corporation’s mission and specify strategic options to its
management.
BOARD OF DIRECTORS COMPOSITION
• Inside directors (sometimes called management directors) are typically officers or executives employed by the
corporation.
• Outside directors (sometimes called non-management directors) may be executives of other firms but are not
employees of the board’s corporation.
• This view is in agreement with agency theory, which states that problems arise in corporations because the
agents (top management) are not willing to bear responsibility for their decisions unless they own a substantial
amount of stock in the corporation.
• Stewardship theory proposes that, because of their long tenure with the corporation, insiders (senior executives)
tend to identify with the corporation and its success.
NOMINATION AND ELECTION OF BOARD OF DIRECTORS
• Traditionally, the CEO of a corporation decided whom to invite to board membership and merely asked the
shareholders for approval in the annual proxy statement. All nominees were usually elected.
• This is especially likely given that only 7% of surveyed directors indicated that their company had term limits for
board members. Nevertheless, 60% of U.S. boards and 58% of European boards have a mandatory retirement age
—typically around 70.
• Many corporations whose directors serve terms of more than one year divide the board into classes and stagger
elections so that only a portion of the board stands for election each year. This is called a staggered board
ORGANIZATION OF THE BOARD
• The CEO is supposed to concentrate on strategy, planning, external relations, and responsibility to the board.
• The Chairman’s responsibility is to ensure that the board and its committees perform their functions as stated in
the board’s charter.
• Many of those who prefer that the Chairman and CEO positions be combined agree that the outside directors
should elect a lead director.
• The most effective boards accomplish much of their work through committees. Typical standing committees (in
order of prevalence) are the audit (100%), compensation (99%), nominating (97%), corporate governance (94%),
stock options (84%), director compensation (52%), and executive (43%) committees.
IMPACT OF SARBANES-OXLEY ON US CORPORATE GOVERNANCE
•In response to the many corporate scandals uncovered since 2000, the U.S. Congress passed the Sarbanes–Oxley
Act in June 2002.
• This act was designed to protect shareholders from the excesses and failed oversight that characterized criminal
activities at Enron, Tyco, WorldCom, Adelphia Communications, Qwest, and Global Crossing, among other
prominent firms.
•IMPROVING GOVERNANCE - In implementing the Sarbanes–Oxley Act, the U.S. Securities and Exchange
Commission (SEC) required in 2003 that a company disclose whether it has adopted a code of ethics that applies to
the CEO and to the company’s principal financial officer.
• EVALUATING GOVERNANCE - To help investors evaluate a firm’s corporate governance, a number of independent
rating services, such as Standard & Poor’s (S&P), Moody’s, Morningstar, The Corporate Library, Institutional
Shareholder Services (ISS), and Governance Metrics International (GMI), have established criteria for good
governance.
• Ownership Structure and Influence
• Financial Stakeholder Rights and Relations
• Financial Transparency and Information Disclosure
• Board Structure and Processes
•AVOIDING GOVERNANCE IMPROVEMENTS - A number of corporations are concerned that various requirements
to improve corporate governance will constrain top management’s ability to effectively manage the company.
TRENDS IN CORPORATE GOVERNANCE
•(1) good governance leads to better performance over time,
•(2) good governance reduces the risk of the company getting into
trouble, and
•(3) governance is a major strategic issue.
ROLE OF TOP MANAGEMENT
• RESPONSIBILITIES OF TOP MANAGEMENT - Top management responsibilities, especially those of the CEO, involve
getting things accomplished through and with others in order to meet the corporate objectives.
• Executive leadership is the directing of activities toward the accomplishment of corporate objectives.
• A strategic vision is a description of what the company is capable of becoming.
• They have many of the characteristics of transformational leaders—that is, leaders who provide change and
movement in an organization by providing a vision for that change.

These transformational leaders have been able to command respect and execute effective strategy formulation
and implementation because they have exhibited three key characteristics:
• 1. The CEO articulates a strategic vision for the corporation: The CEO envisions the company not as it currently is
but as it can become.
• 2. The CEO presents a role for others to identify with and to follow: The leader empathizes with followers and
sets an example in terms of behavior, dress, and actions.
• 3. The CEO communicates high-performance standards and also shows confidence in the followers’ abilities to
meet these standards: The leader empowers followers by raising their beliefs in their own
capabilities.

• Managing the Strategic Planning Process - As business corporations adopt more of the characteristics of a
learning organization, strategic planning initiatives can come from any part of an organization. A survey of 156
large corporations throughout the world revealed that, in two-thirds of the firms, strategies were first proposed in
the business units and sent to headquarters for approval.
 CHAPTER 2: ACCOUNTING CONCEPTS AND PRINCIPLES
BASIC ACCOUNTING CONCEPTS
1. Separate Entity Concept-It is a separate person distinct from the owners. Only the transactions of business are
recorded in the books of accounts while the personal transaction of the owner(s) are not recorded. Meaning, the
business is separate from personal. If you get money from the business it will be recorded in the book of accounts
as a withdrawal of investment from business for personal consumption.
Separate entity concept is necessary so that the financial position and financial performance of a business can be
measured properly. By applying this concept you will know if the business is really earning profits and will have
better accounting information that could help in making better business decisions.
2. Historical Cost Concept(Cost Principle) Assets are initially recorded at their acquisition cost.
3. Going Concern Assumption Under this concept, the business is assumed to continue to exist for an indefinite
period of time. Meaning, the company is not in danger of closure due to insolvency, but can be relied upon to
survive or thrive
4.Matching(Association Cost and Effect) some costs are initially
recognized as assets and charged as expenses only when the related revenue
is recognized. business should match related revenues and expenses in the same period. They do this in order to
link the costs of an asset or revenue to its benefits.
5. Accrual Basis of accounting – economic events are recorded in the period in which they occur rather than at the
point in time when they affect cash.
- income is recognized when it is earned, not when it is collected.
- expense is recognized when it is occurred, not when it is paid.
6. Prudence (Conservatism) - the accountant observes some degree of caution when exercising judgments needed
in making accounting estimates under condition of uncertainty. For example, if accountant needs to choose
between a potentially favorable outcome vs. unfavorable outcome, the accountant will choose the unfavorable
outcome so that assets or income are not overstated and liabilities or expense are not understated.
7. Time Period (Periodicity, Accounting period or Reporting period) – the life of the business is divided into series
of reporting periods.
Reporting period
- it is usually 12 months but can be longer or shorter
 Calendar year period - Jan. to Dec.
 Fiscal year period – starts on a date other than Jan.
An accounting period shorter than 12 months is called “interim period”
8. Stable monetary unit – assets, liabilities, equity, income and expenses are stated in terms of a common unit of
measure.
9. Materiality concept – an item is considered material if its omission or misstatement could influence economic
decisions.
10. Cost-benefit (Cost constraint) – the costs of processing and communicating information should not exceed the
benefits to be derived from the information’s use.
11. Full disclosure principle – information communicate to users reflect a series of judgmental trade-offs that
strive for:
- sufficient detail to disclose matters that make a difference to users,
- sufficient condensation to make the information understandable, keeping in mind the costs of preparing
and using it.
12. Consistency concept – a business to apply accounting policies consistently, and present information
consistently, from one period to another.
ACCOUNTING STANDARDS
Explicit concepts and principles- those that are specifically mentioned in the Conceptual Framework for
financial Reporting and in the Philippine Financial Reporting Standards (PFRS)
Implicit concepts and principles- those that are not specifically mentioned in the foregoing but are
customarily used because of their general and longtime acceptance within the accountancy profession.
Philippine Financial Reporting Standards (PFRS) -are standards and interpretations adopted by
Financial Reporting Standards Council (FRSC).
- They consist of:
1. Philippine Financial Reporting Standards (PFRS);
2. Philippine Accounting Standards (PASs); and
3. Interpretation
Relevant regulatory bodies
1. Security and Exchange Commission (SEC)- Corporation and Partnership
2. Bureau of Internal Revenue (BIR) - Tax Code
3. Bangko Sentral ng Pilipinas (BSP)- Banks and other Banking Institutions
4. Cooperative Development Authority (CDA)- Cooperatives
Qualitative Characteristics of useful financial information
Qualitative characteristics – are the traits that determined whether an item of information is useful to
users.

1. Fundamental qualitative characteristics - these are the characteristics that make information
useful to users, consist of:
- Relevance
- Faithful representation
2. Enhancing qualitative characteristics – these characteristics support the fundamental
characteristics, consist of:
- Comparability
-Verifiability
- Timeliness
- Understandability
Fundamental qualitative characteristics
1. Relevance – information is relevant if it can affect the decisions of users.
a. Predictive value – help users to make a predictions about future outcomes.
b. Confirmatory value (or Feedback value)- help users confirm their past predictions.
c. Materiality – information is material if omitting it or misstating it could influence the decisions of
users.
2. Faithful representation – represents the actual effects of events that have taken place.
a. Completeness – all information necessary for users to have complete understanding of the financial
statements is provided.
b. Neutrality – information is selected or presented without bias .
c. Free from error – information is not materially misstated.

Enhancing qualitative characteristics

1. Comparability – help users identify similarities and differences between different sets of information.
2. Verifiability – different users could reach a general agreement as to what the information intends to
represent.
3. Timeliness – information is available to users in time to be able to influence their decisions.
4. Understandability – information is presented in a clear and concise manner.
 Chapter 4 – TYPES OF MAJOR ACCOUNTS
The Account
Account
• is the basic storage of information in accounting
• It is a record of the increase and decrease in a specific item of assets, liability, equity, income and
expense.
• An account may be depicted through a “T-account.”

The Five Major Accounts

The five major accounts,
- called the elements of the financial statements,
- the items in the expanded accounting equation

1. ASSETS - are the economic resources you control that have resulted from past
events and can provide you with future economic benefits.
2. LIABILITIES - are your present obligations that have resulted from past
events and can require you to give up resources when settling them.
3. EQUITY - is assets minus liabilities.
4. INCOME - is increases in economic benefits during the period in the form of
increases in assets, or decreases in liabilities, that result in increases in equity,
excluding those relating to investments by the business owner.
Income includes both revenue and gains.
a. Revenue arises in the course of the ordinary activities of a business, e.g., sales
and service fees.
b. Gains represent other items that meet the definition of income and may or
may not arise in the course of the ordinary activities of an entity.
5. EXPENSES - are decreases in economic benefits during the period in the form
of decreases in assets, or increases in liabilities, that result in decreases in equity,
excluding those relating to distributions to the business owner.
Expenses include both expenses and losses.
a. Expenses arise in the course of the ordinary activities of a business.
b. Losses represent other items that meet the definition of expenses and may or
may not arise in the course. of the ordinary activities of the entity.

Classification of the Five Major Accounts

BALANCE SHEET ACCOUNTS: ASSETS, LIABILITIES, EQUITY
INCOME STATEMENT ACCOUNTS: INCOME, EXPENSES
Balance Sheet Accounts
ASSETS

Cash - includes money or its equivalent that is readily available for unrestricted use, e.g,, cash on hand

and cash in bank.

Accounts receivable - receivables supported by oral or informal promises to pay.

Allowance for bad debts - the aggregate amount of estimated losses from uncollectible accounts

receivable. Another term is "allowance for doubtful accounts."

Notes receivable - receivables supported by written or formal promises to pay in the form of

promissory notes.

Inventory-represents the goods that are held for sale by a business. For a manufacturing business,

inventory also includes goods undergoing the process of production and raw materials that will be

consumed in the production process.

Prepaid supplies - represents the cost of unused office and other supplies.

Prepaid rent - rent paid in advance.

Prepaid insurance - cost of insurance paid in advance.

Land -the lot on which the building of the business has been constructed or a vacant lot which is

to be used as future plant site. Land is not depreciable.

Building - the structure owned by a business for use in its operations.

Accumulated depreciation - building - the total amount of depreciation expenses recognized

since the building was acquired and made available for use.

Equipment - consists of various assets such as:

a. Machineries and other factory equipment

b. Transportation equipment, e.g., vehicles, delivery trucks
c. Office equipment, e.g., desks, cabinets, chairs
d. Computer equipment, e.g., server, personal computers, laptops
e. Furniture and fixtures, e.g., desks, cabinets, movable partitions
Accumulated depreciation - equipment - the total amount of depreciation expenses recognized

since the equipment was acquired and made available for use.

Collectively, land, building and equipment are referred to as “Property, plant and equipment,"

“Capital assets," or "Fixed assets."

Balance Sheet Accounts
LIABILITIES

Accounts payable -obligations supported by oral or informal promises to pay by the

debtor. ·

Notes payable - obligations supported by written or formal promises to pay by the

debtor in the form of promissory notes.

Interest payable - interest incurred but not yet paid. Interest payable arises from nterest-bearing liabilities.
For example, you will incur interest on your bank loan.

Salaries payable - salaries already earned by employees but not yet paid by the business.

Utilities payable - utilities (e.g, electricity, water, telephone, internet, cable TV, etc.) already used but not
yet paid.

• the word “receivable” cannotes as asset, while the word “payable”

connotes a liability.

• The word “prepaid” connotes as asset, while the word “unearned”

connotes a liability.
Income Statement Accounts

INCOME

Service fees -revenues earned from rendering services (e.g. services of a spa, services of a beauty salon,
etc.).

Sales-revenues earned from the sale of goods (e.g, sale of barbecue, sale of souvenir items, etc.).

Interest income - revenues earned from the issuance of interest-bearing receivables.

Gains-income earned from the sale of assets (except inventory) or from enhancements of assets or
decreases in liabilities that are not classified as revenue.

Income Statement Accounts

EXPENSES

Cost of sales (or Cost of goods sold) - represents the value of inventories that have been sold during the
accounting period.

Freight-out- represents the sellers' costs of delivering goods to customers. Other terms for freight-out are
“delivery expense," “transportation-out," and “carriage outwards.”

Salaries expense - represents the salaries earned by employees for the services they have rendered
during the accounting period.

Rent expense - represents the rentals that have been used up during the accounting period.

Utilities expense- represents the cost of utilities (e.g" electricity, water, telephone, internet, cable TV, etc.)
that have been used during the accounting period.
A business can also have separate accounts for each type of utility, é.g., “Electricity
expense," "Water expense," "Technology and Communication expense,” and the like.

Supplies expense - represents the cost of supplies that have been used during the period.

Bad debt expense - the amount of estimated losses from uncollectible accounts receivable during the
period. Other term is “doubtful accounts expense."

Depreciation expense - the portion of the cost of a depreciable asset (e.g., building or equipment) that has
been allocated to the current accounting period.

Advertising expense-represents the cost of promotional or marketing activities during the period.

Insurance expense - represents the cost of insurance pertaining to the current accounting period.

Taxes and licenses -represents the cost of business and local taxes required by the government for the
conduct of business (e.g, mayor's permit, other percentage taxes, community taxes).

Transportation and travel expense

Transportation expenses represent the necessary and ordinary cost of employees getting from one
workplace to another which are reimbursable by the business, e.g, reimbursable taxi fares of employees
running some errands and those who are working on late shifts.
Travel expenses represent the costs incurred when travelling on business trips, e.g,,
out-of-town travel costs of employees sent to seminars.
Income Statement Accounts

EXPENSES

Interest expense-represents the cost of borrowing money.It is the price that a lender charges a borrower
for the use of the lender's money. Other terms for interest expense are finance costs and borrowing costs.

Interest expense and interest income are opposites. For example, you will incur interest expense
on the money you borrowed from Mr. Bombay. On the other hand, Mr. Bombay will earn interest
income.

Miscellaneous expense- represents various small expenditures which do not warrant separate
presentation.

Losses - expenses which, may or may not arise from the ordinary course of business activities. Losses
may arise from:

a. Sale of assets, other than inventory, at a sale price that is less than the carrying amount.

b. Decreases in the value of assets due to destruction, damage, obsolescence and other changes in
values caused by market factors, e.g., loss on fire, earthquake, storm, and other calamities, decrease in
the value of foreign currencies held due to changes in exchange rates.

The term “earned” relates to income, while the term “incurred” relates to expenses.

• The “unused” portion of a cost is an asset, while the “used” portion is an expense.
 CHAPTER 1: ECONOMIC DEVELOPMENT
The study of the proper allocation and efficient use of scarce resources to produce commodities for the
maximum satisfaction of unlimited human needs and wants.
NEEDS are essentials for human survival like food, clothing, and shelter
WANTS are goods that give more satisfaction and make life more pleasant and worth living

GOALS OF ECONOMIC
To strengthen economic freedom
• an individual should have complete control of what to consume, his/her choice of work and
where it is located, or which business to undertake
• Economic freedoms include consumer choice, freedom of occupational choice, freedom to
consume or save, freedom ta own properties, and freedom of enterprise.
To promote economic efficiency
 Efficiency is producing more output with the use of fewer resources. There are many factors
that contribute to efficiency, such as modern technologies (new tools and machines) and
managerial skills.
For example, by prohibiting the importation of cars, the Philippines can attempt to produce these
goods; producers might have the efficiency at hand.
To promote economic stability
 Stability means there are no violent ups and downs in the economy. The goal is a consistent
growth in a changing world, thus, the movement of output of the economy, employment, and
prices of goods and services should be kept at reasonable ranges.
To promote economic security
 People with corresponding skills, capital, and assets are sold in exchange for income, and the
value of those agents depends on the worth of the final goods and services produced by them.
To attain a high level of growth in the economy
 Economic growth means that the capacity to produce goods and services is increasing, and it is
growing more rapidly than the population.
two factors:
(1) expansion in the resources available for producing goods
and services, such as, a larger labor force and larger capital stock
(2) improved skills and technology, including managerial and entrepreneurial skills, so that more
goods and services can
be produced from given resources.

Two basic responsibilities in promoting economic growth

(1) to provide law and order that will create a conducive
investment climate, such as enforcement of contracts and the preservation of environment
(2) to provide public services that the private sector cannot provide but are important for an expanding
economy.

ECONOMICS RELATED TO OTHER SOCIAL SCIENCES

These social sciences are distinctly
related to one another because they study the social life of human beings but differ in methods of
analysis and objectives. We now enumerate five social sciences that are most related to
economics.
Anthropology
- is a branch of science that studies the biological, psychological, social, and cultural aspects of human
life.
- comes from the Greek words Anthropos and logus which together mean "study of group or people."

Political Science
The word political comes from the Greek word polis which means "city" or "state" and
science comes from the Latin word scire which means "to know." Hence, political science is a systematic
study of the state and government.
-because it studies the mechanics of the distribution of power, and its primary concern is to find out the
relationship between the authority
and the masses. Political science also gives us information on the main role or task of people
occupying different positions in the government.

Sociology
Sociology comes from the Greek words socius and logus which together mean "study of
the society or study of groups or partners. It studies the society by means of analyzing human
groups, institutions, and its social relationship. It analyzes the social patterns that result from
numerous individual interactions.
-In economics, sociology focuses on social relations, social organizations, social interact social structures,
and social processes. It also deals with various social issues and problems,
ethnic relations, family life, social mobility, and accessibility of the people in the society.

Psychology
Psychology is derived from the Greek words psyche which means "soul" and logus which means "study."
Psychology is defined as the scientific study of the behavior and living organisms with special attention
to human behavior.
-Psychology gives us an idea on how it is related to economics through mind conditioning that influences
an individual's perception and
Decision

History
History is a social science that focuses on the study of past events. Through history, we are able to
compare the things that happened in the past and correlate them with what is happening at the present
time.
.
BRANCHES OF ECONOMICS (Microeconomics and Macroeconomics)

Microeconomics deals with the behavior of individual components such as household, firm, and
individual owner of production.

Macroeconomics deals with the behavior of economy as a whole with

the view of understanding the interaction between economic aggregates such as employment,
inflation, and national income. It consolidates all goods and services together and look at the economy
by focusing on employment generated by the different industries.
METHOLOGIES OF ECONOMICS (Positive and Normative Economics)

Positive economics relates to what is. It is an economic analysis that explains what happens in the
economy and why, without making any recommendations to economic policy, or in simple idea, it deals
with how the economy works.

Normative economics, on the other hand, concerns itself with what should be. It is an economic
statement that makes recommendation to economic policy.

THE SCIENTIFIC METHOD OF ECONOMICS: Economics, being a science, is a systematic body of

knowledge. Economists have developed techniques, referred to as the scientific approach or method in
data gathering, data presentation, and data analyses, that make a starting point in understanding
economic issues and eventually lead to creating decisions.

Data Gathering
Economic knowledge is mostly obtained from observation of economic events. Data is obtained through
historical records and even interviews of past performances
which organized in a way that can be easily analyzed. This is sometimes called the empirical
method.

Economic Analysis
Data gathered is useless if not analyzed. Raw data alone cannot tell the
reality. Hence, in order to synthesize observed data, economic analysis is induced for the
recorded data. It is an approach which predicts economic behavior on the basis of assumptions.

Economic Conclusions
After laying down all assumptions, one proceeds to reasoning in
order to generate conclusion. Reasoning can either be verbal or with the help of statistic.
Reasoning is categorized into: inductive reasoning, which is the process of reasoning from
particular to general; and deductive reasoning, which is the process of reasoning from general
to the particular.

Classical Economics
The central idea of classical economics is that free markets can regulate themselves. This is because in a free
market economy, people act in their own self-interest, causing prices to rise or fall so that supply and demand will
always return to equilibrium.
According to Adam Smith, "Selfish behavior by individuals leads to an outcome that
benefits everyone in society". This statement summarizes the most important idea that serves as
basis of classical economics.

The labor theory of value unified the theories of the classical economists, which is different
to value drawn from a general equilibrium of supply and demand. The classical economists
observed economic and social transformation brought by the industrial revolution. They also
posted many questions about value, economic growth, and money in the economy. They maintain
a free-market economy, disputing natural system based on freedom and property. But these
economists were at odds and cannot arrive at a specific thought.
Consumption theory, as developed by the Birmingham School and Malthus in the early
19th century, argued that government interventions must alleviate unemployment and economic
fluctuations. Moreover, this theory influenced Keynesian economics later on in the 1930s. Another
distinguished school of thought was Manchester capitalism, which campaigned for free trade
against mercantilism.

Classical economics can be divided into two branches: the general equilibrium theory and the theory of money.
General equilibrium theory, advanced in 1874 by Léon Walras, explained how much of each good is created and
how the price of each good is related to every other good. This theory is about money prices as
opposed to real quantities and relative prices. It aims to tell us what determines how much dollars
an average person will earn for an hour's work, or how much pesos you will have to pay for a cell
phone and the money cost to have a holiday in Boracay.

The quantity theory of money is also used to understand what determines the rate of inflation.

Classical economics, as embodied in general equilibrium theory and the quantity theory
of money, is worth understanding because it has influenced the thinking of all living economists
today. Even those who reject its relevance as an explanation of the real world still use classical
economics as a benchmark against which to measure the performance of real-world economies.

Neoclassical Economics
Neoclassical economists presumed an element of irrationality in the context of inter-temporal decision
making.
It is commonly held that neoclassical economics has two main interpretations of rationality:
internal consistency and the maximization of self-interest.

Keynesian economics

Keynesian economics are the various macroeconomic theories and models of how aggregate demand strongly

influences economic output and inflation.

Keynesians believe that, because prices are somewhat rigid, fluctuations in any component of
spending—consumption, investment, or government expenditures—cause output to change. If
government spending increases, for example, and all other spending components remain constant,
then output will increase.

Monetarism
The most important tenet of monetarism is that money matters-and it matters a lot. lt is the
crucial determinant of how the overall economy performs. Monetarism talks about the supply of
money, that is, the total quantity of money in the system and how fast it is rising or falling.
Monetarists are normally not interested in interest rate. Keynes, on the other hand, put less
emphasis on monetary variables and focused on interest rates. The precise definition of money
supply is far less important to the monetarists than how it changes over time.

Rational Expectations (New Classical Economics)

Rational expectations theory (conceptualized by Robert Lucas and Thomas Sargent)
states that people understand how the economy works and use all information available to them
in making their economic decisions. Thus, when the government changes its economic policy,
people anticipate the consequences of the change and alter their behavior accordingly, which
nullifies the intent of the policy change.
Chapter 3
Elements of Supply and Demand

Law of Demand
The law of demand states that as price increases, quantity demanded decreases; and as price
decreases, quantity demanded increases, if other factors remain constant (eeteris paribus).
Validity of the Law of Demand
The law of demand is only true ceteris paribus. For example, if the price of iPad decreases by 50%
from its original price, then the quantity demanded for such item increases. This is only true if other
variables remain constant such as the consumer's income. Suppose that the income of the
consumer decreases by around 75%, the quantity demanded for such product will fall even though
the price decreases because the consumer has less purchasing power brought by the decline in
income.
Justification for the Law of Demand
1. Income Effect. When the price of goods decreases, the consumer can afford to buy more of it or
vice versa. This simply implies that at a lower price, the consumers have a greater purchasing
power.
2. Substitution Effect. It is expected that consumers tend to buy goods with a lower price. Hence, in
case that the price of goods that consumers buy increases, they look for substitutes with a lower
price.

Determinants of Demand
Determinants of demand are those that actually influence the quantity of demand. Aside from the
price that influences the quantity demanded as stated in the law of demand, there are also other
factors that should be given consideration.
These are referred to as non-price determinants enumerated below:
1. Consumers' Income. A change in income will cause a change in demand. The direction in which
the demand will change in response to a change in income depends on the following types of
goods:
a. Normal Good. Refers to a good for which demand at every price increases when income rises or
vice versa. Example would be goods that are considered as part of our basic necessities
such as rice, utilities (electricity and water), medical and dental services.
b. Inferior Good. Refers to a good for which demand falls when income rises and vice versa. Public
transportation is a good example-as income of passengers in Manila increase significantly, they
tend to reduce their consumption for the services of public utility vehicles (PUVs) as mode of
transportation and instead drive their own car.
2. Consumers' Expectation of Future Prices. The quantity of a good demanded within any period
depends not only on prices in that period but also on prices expected in future periods. When
someone expects higher prices in the future especially for the price of gasoline, the tendency
for car owners is to buy more gasoline immediately (panic buying) to maximize the purchasing
power of their money. In the same manner, demand for gasoline decreases if car owners expect
prices to decline in the future.
3. Prices of Related Products. The demand for any particular good will be affected by changes in the
prices of related goods. The direction in which the demand will change in response to a change in
prices of related products depends on the following relationships of products:
a. Substitute products are goods that can be used in place of other goods. They are related in
such a way that an increase in the price of one good causes an increase in the demand for
the other good or vice versa.
b. Complementary products are goods that go together or cannot be used without the other. They
are related in such a way that an increase in the price of one good will cause a decrease in the
demand for the other good.
4. Consumers' Tastes and Preferences. Consumers' tastes and preferences are major factors in
determining the demand for any product. Religion, culture, traditions, and age are some of the
factors that can affect them. As preference and taste become inclined for a certain product,
demand will certainly increase for that product or vice versa. For example, Filipinos are becoming
more health conscious and as a result, the demand for herbal supplements has increased
substantially.
5. Population. An increase in the population means more demand for goods and services. Inversely,
less population means less demand for goods and services. China is fast becoming an economic
superpower as investments are continuously flowing to their economy. The main reason for this is
its huge market of 1.8 billion that has attracted investors from the US, and Europe.

Demand Schedule
The demand schedule shows the tabular representation of the relationship between the quantity of
a good demanded and the price of that good. Other factors that may affect the quantity demanded,
such as the prices of other goods, are held constant in drawing up the demand schedule.
Demand Curve
After deriving the demand schedule, we can now draw the demand curve. It shows graphically the
relationship between the quantity of a good demanded and its corresponding price, with other
variables held constant. The demand curve is typically downward sloping. It describes the negative
relation between the price of a good and the quantity that consumers want to buy at a given price.

This downward sloping property of the demand curve is referred to as the laws of downward
sloping demand. Thus, greater quantity will be demanded when the price is lower, and when the
price of goods increases, buyers tend to buy less of them.

Change in Quantity Demanded (AQd) versus Change in Demand (AD)

Change in Quantity Demanded. It is due only to a change in the price of goods and services.
Graphically, it is represented by a movement along a demand curve which indicates a movement
from one point to another point of the same demand curve.

Change in Demand. It is brought by the changes in the non-price determinants of demand.

Supply
The first thought that comes to mind when we hear the word supply is the "availability" of goods
and services as if these are of fixed amounts. For example, someone might say, "There are so many
apartments for rent in Manila." It is because in this city, short buildings have been replaced with tall
ones, and the number of apartments has increased. Supply, as compared to demand, can also
change, and the quantities of goods and services supplied are based on the decisions of the
producers in the market.
Supply is defined as the maximum units/quantity of goods or services producers can offer. The
quantity supplied refers to the amount or quantity of goods and services producers are willing and
able to supply at a given price, at a given period of time.

Law of Supply
The law of supply states that as price increases, quantity supplied also increases; and as price
decreases, quantity supplied also decreases. This means that the higher the price of certain good
and service, the higher the quantity supplied. This is because producers tend to supply more at a
higher price because it could give them more profit.
Validity of the Law of Supply
Just like the law of demand, the law of supply is only correct if the assumption of ceteris paribus is
applied. This means that there is no change in the non-price determinants of supply. For instance,
the price of SUV increases from P4M to P6M, and with the cost of production remaining constant,
the producer certainly gets more profit and is induced to produce more. Assuming that as the price
increases from P4M to P6M, the cost of production also increases and producers may reduce their
quantity supplied or stop altogether if they get no profit anymore.

Determinants of Supply
At any point in time, supply of commodity depends on many factors. Some determinants of supply
are in given as follows:
1. Change in Technology. State-of-the-art technology that uses high-tech machines increases the
quantity supply of goods and services which causes the reduction of production cost. For example,
mass production is not possible without specialized machinery to produce high volumes of
standardized products such as cars, consumer products, and computers.
2. Cost of Inputs Used. An increase in the price of an input or the cost of production decreases the
quantity supply because the profitability of a certain business decreases. Competitive prices
of Chinese products can be attributed to a very low labor cost. A Chinese worker is willing accept a
wage rate of only one dollar per day.
3. Expectation of Future Price. Expectation about future prices can shift the supply curve. When to
producers expect higher prices in the future commodities, the tendency is to keep their goods and
release them when the price rises. Inversely, supply for such goods decreases if producers expect
prices to decline in the future. During natural calamities such as strong typhoons, we experience an
immediate increase in the prices of basic commodities such as rice. This increase can be pointed to
unscrupulous traders who hold the supply of rice in anticipation of a further increase in its price.
4. Price of Related Products. Changes in the price of goods have a significant effect in the supply of
such goods. For instance, an increase in the price of pork may likely encourage poultry raisers to
shift into hog farming if this gives them more profit.
5. Government Regulation and Taxes. It is expected that taxes imposed by the government
increases cost of production which in turn discourages production because it reduces producers'
earnings. A higher degree of regulation will translate to lower supply in the market. For example,
medicine graduates must pass the licensure examinations given by the government to guarantee
that they meet the minimum requirements before they can legally practice their profession. No
doubt, this reduces the supply of medical services in the market.
6. Government Subsidies. Subsidies or the financial aids/assistance given by the government
reduce cost of production which encourage more supply. In Japan, the government is subsidizing
their agricultural sector, any agricultural commodity that is not purchased in the market will be
bought by the government from farmers. This will ensure a steady and continuous supply of that
commodity in the market.
7. Number of Firms in the Market. An increase in the number of firms in the market leads to an
increase in supply of goods and services. The increase in the supply of imported cars in the country
is due to the rise in dealers of those cars such as Ford, KIA, Hyundai, and the like.
Supply Schedule
Supply schedule shows the tabular representation of the relationship between the quantity of a
good supplied and its price. The supply schedule for SUV shows the different quantities supplied
when only ins price changes and other factors affecting the quantity supplied are held constant.

Supply Curve
After developing the supply schedule, the supply curve can now be obtained. The apply curve shows
graphically the relationship between the quantity of a good supplied and its corresponding price,
with other variables held constant. The supply curve is typically upward sloping.

Change in Quantity Supplied (AQs) versus Change in Supply (AS)

Change in Quantity Supplied. Movement along the supply curve is known al a change in quantity
supplied, which shows the movement from one point to another point on the same supply curve.
This is due only to a change in the price of goods and services.

Change in Supply
Shifting from one supply curve to another is called change in supply. This is brought about by a
change in all determinants. A shifting of the supply curve to the right indicates that there is an
increase in supply, and shifting to the left indicates decrease in supply.