Introduction to Economic Theory
Basic economics
Economics: Major Definitions
1. Economics studies how prices of land, labor
and capital are determined, and how these
prices are used to allocate scarce resources.
2. Economics looks into the behavior of financial
market and how they allocated capital to the rest
of the economy.
3. Economics looks into the distribution of income
and into ways of helping the poor without
causing harm to the country’s economic
performance.
Economic Activity
(Man’s basic economic activity consists of efforts to
satisfy human wants with the use of goods and
services.)
Three Elements of Economic Activity
1. Human Wants
- are unlimited
- vary from the needs for survival otherwise
known as basic needs (e.g. food, clothing &
shelter) to higher needs for a
comfortable and more meaningful life.
Man is subject to created wants, developed due
to the effects of advertising and demonstrative
effects of consumption.
2. Use of Resources
- basic economic resources of a nation consists
of land, labor, capital
- available in limited amounts; has to be
allocated properly in order to maximize the
number of wants that can be satisfied.
- the economy should pay for the use of these
factors of production (rent for land; wage/salary
for labor; interest for capital; and profit for
entrepreneurship).
3. Technique of Production
- shows how resources are used and
combined in production
- can be described as capital-intensive or
labor-intensive depending on what factor is
predominantly used.
Consumption
-the household is the basic consuming unit in
the economy.
Some Economic Problems
1. Unemployment of labor or other resources;
2. Economic instability that causes highs and lows
in production and investment levels;
3. Low levels of growth and development;
4. Inequality in income and distribution;
5. Determination of the type of economic system to
adopt to fit the country’s peculiar conditions and
needs.
Economic Analysis
- Is the process of directing economic
relationships by examining economic behavior
and events, and determining the causal
relationships among the data and activities
observed.
4. Economics studies the impact on growth of
government spending, taxes, and budget
deficits.
5. Economics examines the movements in income
and employment during the different stages of
the business cycle with the goal of developing
government policies that will improve economic
growth.
6. Economics looks at trade patterns among
nations and analyzes the impact of trade
barriers.
7. Economics examines growth in developing
countries and suggests ways to encourage the
efficient use of resources.
Tools of Economics
1. Logic – draw conclusions using inductive or
deductive reasoning
2. Statistics – quantitatively describe economic
behavior and serves as basis in hypothesis
testing
3. Mathematics – enables to conceptualize and
quantify a hypothesis for empirical validation
Purposes of Economic Analysis
1. Is an aid in understanding how economy
operates because it explains how economic
variables are related to one another.
2. It permits prediction of the results of changes in
the economic variables.
3. It serves as basis of policy formulation.
Economic Policy
 Consists of intervention or courses of action
taken by the government or other private
institutions to manipulate the results of economic
activity.
 To make a useful, systematic study of economic
activity, one must use economic theory.
 Economic theory consists of set of principles or
causal relationships among the important “facts”
or variables that surround and permeate
economic activity.
Steps in the Construction of Economic Theory
1. The specification and definition of its postulates.
2. The observation of “facts” concerning the activity
about which we want to theorize.
3. Application of the rules of logic to the observed
facts in order to reach a tentative
conclusion/statement (hypothesis).
4. Once hypotheses have been formulated, they
must be thoroughly tested.
Functions of Economic Theory
The principal functions of economic theory fall into two
categories:
1. To explain the nature of economic activity; and
2. To predict what will happen to the economy as
facts change.
Economists differentiate between positive economics
and normative economics on the basis of whether the
users of theory are concerned with causal relationship
only or whether they intend intervention in economic
activity to alter the course of that activity.
Microeconomics & Macroeconomics
Price theory (microeconomics) and the theory of the
economy as a whole (macroeconomics) constitute the
basic analytical tool kit of the discipline of economics.
Microeconomics
- Is concerned primarily with the market activities
on individual economic units such as
consumers, resource owners, and business
firms.
 It is concerned with:
a. Flow of goods & services from business firms to
consumers
b. Flow of resources (or their services) from
resource owners to business firms
Macroeconomics
- Treats the economic system as a whole rather
than treating the individual economic units of
which it is composed of.
- The value of the overall flow of goods (net
national product) and the value of the overall
flow of resources (national income) receive the
focus of attention.
Characteristics of Microeconomics
1. Microeconomics looks at the decisions of individual
units. (e.g. households, producers, firms)
Relevant questions:
- How efficiently are we using our resources?
- Could we obtain more output from the same
resources if we reorganized the ways we use
them?
2. Microeconomics is concerned with how prices are
determined in various types of market structures.
(e.g. pure competition, monopoly, monopolistic
competition & oligopoly)
Relevant questions:
- Should a monopolist increase his price?
- Should a producer in an oligopolistic market
lower his
price?
- Can a producer under a purely competitive
market increase his price?
3. Microeconomics is concerned with social welfare.
Relevant questions:
- Is it prudent to build a new bridge or to buy
additional arms for the army?
- Is it wise to impose price control?
- Should the government limit the controlling
interests in media?
4. Microeconomics has a limited focus. Problems
dealing with the aggregate economy are within the
domain of macroeconomics. (e.g. economic issues,
aggregate level of employment of resources, rate of
inflation)
5. Microeconomics develops skills.
Set of useful and marketable skills:
 Logical reasoning
 Skill in the construction and use of models
 Employ optimizing techniques (decision-making
in variety of situations)
 Personal resource allocation decisions (career
choices or financial investments)
Economic Models
 Composed of a series of statements of
assumptions or given and statements of
implications or deductions. (e.g. competitive
market or “supply and demand”)
 Economic models could be expressed in three
different forms: verbal (or logical), mathematical
and graphical.
Economic Model: Law of Supply
 Verbal or logical
Supply is a schedule of prices and quantities that a
supplier would be willing to offer for sale at each price
per period of time. Prices and quantity offered for sale
are directly related, i.e. the higher the price, the more
supply; the lower price, the less supply.
 Mathematical notations
Mathematical notations are shortcut representation of
verbal explanations. The law of supply can be expressed
succinctly in an equation: Qs = 500P
 Graphical
If we compute the supply schedule as expressed
in the equation, Qs=500P, we will have the following
table:
Supply Schedule
Price Quantity Supplied
1 Php 500
2 1,000
3 1,500
4 2,000
5 2,500
6 3,000
Partial equilibrium analysis
-Compared equilibrium changes for one decision
unit or one market independent of related
changes in the economic system. Under ceteris
paribus assumption.
Qd = f(P)
Demand for a commodity depends on its price
General equilibrium analysis
- Recognizes the interdependence of all decision
units and all markets in the economic system. It
examines changes within the context of the
entire system.
Qd= f(P, Y, Po, Pe, Ad)
Includes all possible variables that would affect
demand
Basic Economic Problems
1. What to produce?
2. How much to produce?
3. How to produce?
4. For whom to produce?
Types of Economic System
Traditional economic system. Production decisions
are made according to customs and traditions. This
system is simple and easy but does not allow
progress to be introduced in the production
techniques.
Command economy. The answers to the basic
economic problems are dictated by the government
that makes the decisions. This system is socialistic
as the government owns and controls the factors of
production.
Market system. Deals with the economic problems by
considering consumers’ choices. The indicators
are consumers’ demand in the market as
reflected in the prices of goods and services.
Terms to Remember
 Economics – a social science concerned with
man’s problem of issuing scarce resources to
satisfy unlimited wants.
 Basic needs – man’s needs required for his
survival
 Luxury goods – goods that man can do without
 Economic resources – inputs used in the
production of goods and services
 Land – natural resources, not man-made,
covering anything found on or under land,
including water, forests, minerals and animals
 Labor – human effort expended in production
regarding basic economic problems
 Entrepreneur – organizes all other factors of
production to be used in the creation of goods
and services
 Capital – materials used in the production of
goods and services including money
 Theory/Hypothesis – an unproven proposition
tentatively accepted to explain certain facts or to
provide a basis for further investigation
 Variable – a factor that is subject to change or
variations
 Macroeconomics – the branch of Economics
that studies the economy as a whole, also
known as National Income Analysis
 Microeconomics – the branch of Economics
that deals with parts of the economy such as the
household and the business firm. It is also
known as Price Theory
 Normative economics – an analysis of
economics which deals with what should be
 Positive economics – an analysis of
economics which deals with what actually is
 Empirical validation – the use of statistical
evidence to prove the validity of the hypothesis
 Economic system – the means by which an
economy reaches decisions
 Free enterprise system – a system in which all
economic resources are privately owned.
Individuals are free to engage in the business of
their choice
 Right to private property – the right of private
individuals and enterprises to own things of
value
 Market – context in which buyers and sellers
buy and sell goods, services and resources
 Wants – the various desires and needs of
consumers that have to be satisfied through the
use of goods and services
 Function – depicts the relationship between two
or more variables. It shows how one variable,
called the dependent variable, depends on
another variable, called the independent variable