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Introduction and Overview on Principles in Economics with Taxation and Agrarian

Reform

Hi, and welcome to Principles in Economics with Taxation and Agrarian Reform. In this
course, we will work together to understand the basic principles and theories about
economic concepts that are applied to the Philippine setting. Also, in this course, we will
be introduced to the concepts and importance of taxation, land reform, and
cooperatives.

By the end of the course, you are expected to:

1. Demonstrate an understanding of the world by exploring different methods to


identify, solve problems and make decisions using critical and creative thinking;
2. Acquire understanding of basic economic theories and vocabularies that will
allow them to debate or communicate the essentials of this course;
3. Evaluate the relevance of each given concept or theory in a given context and/or
personal experience;
4. Research, collect, analyze and interpret data as well as other economic
information in order to solve real life problems and make informed and rational
decisions; and finally
5. Apply in a responsible and accountable manner the principles that underlie basic
economic processes and practices.

Some would say that this is a challenging subject. But let me help you get your gear
ready by challenging your interest to give it a try.

Are you ready? Let’s begin with Principles in Economics with Taxation and Agrarian
Reform
Adam Smith
( 5 June 1723 – 17 July 1790)
“Father of Modern Economics.”

Economics is a science of wealth where wealth means


goods and services transacted with money.
Alfred Marshall
(1892-1924)

Economics is the study of people in the ordinary


business of life. It includes the study of labor, land and
capital, investment of money, income and production,
taxes and government.
Lionel Robbins
(22 November 1898 – 15 May 1984)

“Economics is the science which studies human


behavior as a relationship between ends and
scarce means which have alternative uses”.
Gerardo P. Sicat
(1935- present)

Economics is a study of how economic units or agents (individuals,


families, firms, industries, localities, nations) make choices that involve
the use of scarce resources. The choices relate to the solution of
“economic problems” (such as production, consumption, distribution).
The practice of evidence-
based decision
making involves using
current information to make
empirically supported
decisions
Studying economics is vital
on your study of the
complex society where you
belong and your
interactions and
relationships with other
people.
A branch of economics that focuses on the relationship
between social behavior and economics.

Social economics examines how social norms, ethics


and other social philosophies that influence consumer
behavior shape an economy
References

McConnel, C. et.al (2012). Economics: Principles, Problems, and Policies


(Global Edition). McGraw Hill Co., Inc.
Paraiso O.C. et.al (2011). Introduction to Microeconomics, Mutya
Publishing House, Inc.
Stock W.A., (2013) Introduction to Economics: Social Issues and
Economic Thinking

Websites:
http://chestofbooks.com/finance/economics/
http://www.econguru.com//
http://www.ehow.com/\
https://www.google.com.ph
http://www.investopedia.com
http://sundaramponnusamy.hubpages.com
http://www.merriam-webster.com/dictionary
http://wiki.answers.com/
http://wikieducator.org
http://en.wikipedia.org/
Introduction to Economics

1
Introduction to Economics
Man is a rational being and we make minor to major decisions in our life. We make choices,
after weighing the costs and benefits of that decision. Throughout our lives, we are exposed to
different situations where we have to decide and choose from the set of options laid to us. As a
student, what college or university to enroll in, what degree program to take, to rent an apartment
or bed space, to take the jeep or bus in going to school, how to spend your allowance, are all
realities that you have to contend with. How one decides and behaves are based on certain
economic considerations. On a wider perspective, the government policies and program, market
prices, taxes, employment, environmental issues, trade, economic growth and development,
poverty among others will be better understood on the purview of economics.

Objectives:

After studying this chapter, the students should be able to:

1. Analyze and explain the definition of economics;


2. Discuss the importance of studying economics;
3. Explain the relationship of economics with other sciences;
4. Identify wants/needs, resources and the corresponding factor payments;
5. Explain the relationship between scarcity and choice using production possibilities curve;
6. Discuss the fundamental economic problems;
7. Identify the economic tools; and
8. Explain and correlate terms and concepts used in the chapter.

A. Economics Defined
Economics originated from the Greek term
oikonomus which means “one who manages a household”.
The limited resources available to the family are being
allocated among its members taking into account the needs,
priorities, and abilities of each member. The workings of
the household are also happening on the bigger scale, the
society as a whole. How society uses its resources to
produce goods and services, the market behavior,
employment, trading, savings, economic policies,
government programs, are part of the study of economics.

Principles of Economics, Taxation and Agrarian Reform


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Introduction to Economics

Some definitions of economics are as follows:

According to Adam Smith (5 June 1723 – 17 July 1790),


economics is a science of wealth where wealth means
goods and services transacted with money. He also
identified the four aspects of wealth: 1) Production of
wealth or how goods and services are produced; 2)
Exchange of wealth to satisfy wants and needs; 3)
Distribution of wealth (goods and services) to members of
society; and 4) Consumption of wealth or using up the
utility of goods and services for satisfaction of wants.
Adam Smith is the “Father of Modern Economics.”

Alfred Marshall (1842-1924) defined economics as the


study of people in the ordinary business of life. It includes
the study of labor, land and capital, investment of money,
income and production, taxes and government.

2 Principles of Economics, Taxation and Agrarian Reform


Introduction to Economics

Lionel Robbins (22 November 1898 – 15 May 1984) said


that economics is the science which studies human
behavior as a relationship between ends and scarce means
which have alternative uses.

Gerardo P. Sicat (1935- present), on the other hand,


identified economics as a study of how economic units or
agents, such as the individuals, families, firms, industries,
localities, nations, make choices that involve the use of
scarce resources. The choices relate to the solution of
“economic problems” (such as production, consumption,
distribution).

Common to all definitions is the concept of scarce


resources which should be properly managed and
allocated to the production of goods and services needed
to satisfy the insatiable human wants and needs .
Economics deals with production, distribution, and
consumption of goods and services for man’s satisfaction.

Principles of Economics, Taxation and Agrarian Reform


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Introduction to Economics

B. Importance of Economics
Why do we need to study economics?

1. Economics is a science of choices. Studying


economics can improve your decision-making skills,
enabling you to make better decisions.
2. Economics uses logical and evidence-based approach
in analyzing problems. Studying economics can
develop your qualitative and quantitative skills and
improve your critical-thinking skills.
3. Economics deals with people. Studying economics is
vital in your study of the complex society where you
belong and your interactions and relationships with
other people.
4. Equipped with knowledge of the economics tools and
principles, you can gain a better understanding of the
current issues, whether local, national, and global and
view the issue/s with objectivity.

C. Economics and other Social Sciences


Science which came from the Latin word scientia
meaning "knowledge" refers to any systematic
knowledge or practice acquired through scientific
method and research.
Economics is classified as a social science which
deals with a study of human behavior and interactions,
whether individually or in groups. How does economics
relate to other sciences?

a) Psychology is defined as the science of the mind and


behavior and the way a person or group thinks. The
demand for goods and services greatly depends on
individual tastes and preferences. Behavioral economics
is concerned with how the psychological and emotional
states of an individual or a group affect economic
decisions and economic activities. Economic activity is
the work that people do to enhance their quality of life.

b) Mathematics is the science of numbers and their


operations, interrelations, combinations, generalization
and abstractions. Most economics theories are
described in mathematical and statistical models.
Economic analyses and forecasting employ

4 Principles of Economics, Taxation and Agrarian Reform


Introduction to Economics

econometrics, statistics, calculus, and linear


programming, as the case may be.

c) Sociology is the systematic study of the development,


structure, interaction, and collective behavior of
organized groups of human beings. Intertwined with
these are economic activities like the growth and
shrinkage of the economy measured in terms of gross
national product (GDP), employment, consumption,
goods and services, inflation and market trends.

d) Political Science refers to the study of government and


how it works. The government sets and implements
economic policies geared towards economic growth.
Fiscal policies provides for the proper allocation of
public funds from sourcing to utilization. Monetary
policies include those which affect banking regulations,
money supply, interest, prices, and inflation among
others. Trade policies are the set of rules and
regulations on how we do business, domestically and
internationally. These economic policies are the links
between economics and political science. The economic
agenda presented by a political candidate affects his
chances of getting elected.

e) Logic is the science of reasoning and correct thinking


to determine if a given statement is valid or not.
Economics uses logical and evidence-based approach in
analyzing problems and drawing out conclusions, thus
applying the principles of logic.

f) Philosophy refers to the most basic beliefs, concepts,


and attitudes of an individual or group. Economics is a
social science and one branch of philosophy which
relates much to economics is ethics, an area of study
dealing with what is morally right or wrong.

g) History is the study of past events. It is related to


economics because the economic activities done in the
past like consumption patterns, economic policies set,
economic systems implemented, all contributed to a
country’s history.

Principles of Economics, Taxation and Agrarian Reform


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Introduction to Economics

D. Human Wants and Resources

Consumption is a branch of economics, which deals with


the satisfaction of human wants and needs. Needs are
material items people need for survival, such as food,
shelter, and clothing. Wants are desires for commodities
and are the driving forces stimulating the demand for said
goods (tangible) and services (intangible).
Goods are classified into:
a) Capital goods are consumed to produce other goods and
services, hence also termed as production goods. All the
ingredients in baking are capital goods.
b) Consumer goods are goods that directly satisfy human
wants. The food we eat and medical/dental services
availed are examples of consumer goods.
c) Comforts are not strictly necessary for life but they give
pleasure and add to the efficiency of the consumer.
d) Luxury means something that is expensive and not
necessary. Luxuries add to the pleasure of a person but
they do not add anything to his efficiency. Luxuries
have “prestige value.”
It should be emphasized that classification of certain good
or service may vary from one person to another depending
on one’s tastes and preferences, income, beliefs, and other
factors that determine demand.

Characteristics of Human Wants


1. Wants are unlimited. This means that once certain
wants are met, other wants will crop up. We can relate
this to Abraham Maslow’s Hierarchy of Needs:
physiological needs, safety, love/belonging, self-
esteem, and self actualization.

2. Wants are satiable. This characteristic of want states


that its ability to be appeased or satisfied is the basis
for the law of Diminishing Utility.

3. Wants are alternative. It means a particular want may


be satisfied in a number of ways, that is, by the

6 Principles of Economics, Taxation and Agrarian Reform


Introduction to Economics

available substitutes. Thirst can be quenched by


drinking water, soda, or fruit juices of your choice.
4. Wants are competitive. Our wants are unlimited but
means (time, money and other resources) are limited.
One must learn to prioritize and maximize satisfaction
from the limited resources. As stated earlier,
economics is the science of choice.
5. Wants are complementary. In some instances, in
order to be fully satisfied, people resort to the
consumption of more than one good or service. To
some, coffee is better served with cream. There are
also some commodities which are practically useless
without the other like tennis rackets sans tennis balls,
printers and ink cartridges, DVD players and DVDs.

Resources refer to the factors of production which the


economy needs to supply and produce goods and services
to meet the consumption requirements of the individuals
and the society as a whole.
The productive resources are classified as follows:
1. Land or natural resources refer to inputs to
production that are provided by nature such as air,
soil, water, mineral deposits (coal, oil, gold silver).
Natural resources can be classified into renewable
and non-renewable resources. Forest is an example
of a renewable resource because we can have
reforestation to replace trees which can be harvested
after years after. Oil, on the other hand, is a non-
renewable resource for it will be depleted
eventually. Rent is the factor payment for land.

2. Labor or human resource refers to the time and


effort spent by people involved in the production
process. The skills, energy, talent, abilities, and
knowledge that are used for the production of goods
or the rendering of services are classified under
labor. Wage and salary are the payments for the
physical and mental efforts of laborers and workers
and for professionals like doctor, engineers, and
computer programmers.

Principles of Economics, Taxation and Agrarian Reform


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Introduction to Economics

3. Capital refers to the man-made goods used to


produce other goods and services. They are tangible
and physical assets that go into production like
building, equipment, computers, and raw materials.
Money is a medium of exchange used to buy or pay
for the inputs to production. Interest is the factor
payment to the owners of capital.

4. Entrepreneurship refers to the act of organizing and


coordinating land, labor and capital to produce
goods and services and promote business and
economic development. An entrepreneur is a person
who manages the factors of production and assumes
the risks of a business venture. Profit is the
incentive for entrepreneurship, the positive
difference between revenue and all costs of
production.

Characteristics of Resources
1. Resources are scarce and limited.
2. Resources are exhaustible.
3. Resources have alternative uses.

Economics is about managing scarcity of the


limited resources. Deciding on the optimum utilization of
the scarce resources entails cost-benefit analysis.

Scarcity is defined as the realistic condition that


resources are limited and in turn, prevents all human
wants to be fully satisfied. Scarcity arises because people
have unlimited wants while resources are not only limited
but also have alternative uses.

E. Opportunity Cost
Scarcity of resources warrants proper and efficient
allocation of the factors of production among the many
alternative uses. We have to make choices and in the
process, incur opportunity cost, the value of the next best
alternative that must be sacrificed when a choice is made.
The cost of the choice is what you give up to make the
choice, while the benefit is what you gain when you make
the choice.

8 Principles of Economics, Taxation and Agrarian Reform


Introduction to Economics

F. Fundamental Economic Problems


Scarcity pervades in any economy. With society’s infinite
wants and limited resources, it is faced with the following
fundamental economic problems:

 Problem of allocation of resources :What to Produce


This is concerned with the question of which wants
should be satisfied, and which should be left
unsatisfied? Will the scarce resources be used to
produce capital or consumer goods? Choosing one over
the other would mean concentrating the resources to the
chosen economic activity and corresponding reduction
of resources from the production of the other product.

 The problem of all economic efficiency: How to


Produce
Economic efficiency implies an economic state in
which every resource is optimally allocated to serve
each person in the best way while minimizing waste
and inefficiency. When an economy is economically
efficient, any changes made to assist one person would
harm another. In terms of production, goods are
produced at their lowest possible cost, as are the
variable inputs of production.

 For Whom to Produce

Since resources are limited, it is necessary that


producers are assured of markets for their products or
services. The demands of these markets would
determine the types of products, the volume of
production among others. Market research and
feasibility studies can determine for whom to produce.

Principles of Economics, Taxation and Agrarian Reform


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Introduction to Economics

G. Tools of Economics
Economics is a science of choices. One must be
equipped with some basic tools and methods as one
goes through the decision making process. Economic
analysis is an important skill for observing and
understanding economic and socio-political issues
objectively.

1. Logic, the science of reasoning

Students of Economics must develop the critical-


thinking skill: the ability to consciously examine the
elements of one’s reasoning, or that of another, and
evaluate that reasoning against universal intellectual
standards - clarity, accuracy, precision, relevance,
depth, breadth, and logic.

2. Mathematics

Mathematics is regarded as the second language for


the students of economics. Math is the abstract
science which investigates deductively the
conclusions implicit in the elementary conceptions
of spatial and numerical relations, and which
includes as its main divisions geometry, arithmetic,
and algebra. Mathematical tools used in economics
include matrix algebra, linear equations, econometric
models, optimization and differential equations.

3. Statistics

Statistics is the study of the collection, analysis,


interpretation, presentation, and organization of data.
Statistical tools include regression and correlation
analysis and calculation of probabilities.

4. Graphs and Diagrams

A graph or a diagram shows the relationship between


two or more sets of data or variables that are related
to one another. Graph presents a visual picture of an
abstract idea.

10 Principles of Economics, Taxation and Agrarian Reform


Introduction to Economics

A graph has a horizontal line termed as X axis and a


vertical line termed as Y axis. The point of
intersection between X and Y axis is termed as
'origin' point. The surface is divided into quadrants
and each is numbered in anticlockwise direction as
shown below:

The first quadrant depicts the positive values of both X


and Y. It is called positive quadrant, which is generally
used in economics.

Diagrams are pictorial presentations that do not


show quantitative or numerical data, but rather
relationships and abstract information.

.
Basic diagram of the circular flow of income.

Principles of Economics, Taxation and Agrarian Reform


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Introduction to Economics

References:
Mankiw, G.N., (2012). Essentials of Economics 6th Edition.
Harvard University: South-Western, Cengage Learning

Mastrianna F.V.(2013).Basic Economics 16th Edition.


South-Western Cengage Learning

McConnel, C., et.al (2012). Economics: Principles,


Problems, and Policies (Global Edition). McGraw Hill Co.,
Inc.

Paraiso, O.C., et.al (2011). Introduction to


Microeconomics, Mutya Publishing House, Inc.

Stock W.A., (2013) Introduction to Economics: Social


Issues and Economic Thinking

http://chestofbooks.com/finance/economics/
http://www.econguru.com/
http://www.ehow.com/
http://www.investopedia.com
http://sundaramponnusamy.hubpages.com
http://www.merriam-webster.com/dictionary

12 Principles of Economics, Taxation and Agrarian Reform


Elements of Demand
Learning Objectives

1. Explain demand and how it can change.


2. Discuss the relationship between price
and quantity demand.
3. Discuss the determinants of demand.
What is Demand?
Demand is the schedule or a curve of the various
quantities of goods and services that consumers are
willing and able to buy at different prices at a given
time.
Demand Schedule for Demand Curve for
Pandesal Pandesal
Price/ piece Quantity
Demanded
1 55
2 38
3 26
4 18
5 10
Law of Demand
 The law of demand states that, assuming all else is
held constant (ceteris paribus), the quantity
demanded for a good rises as the price falls.
 Inverse relationship exist between price and quantity
demanded.
Determinants of Demand

Demand is the driving force for in any economy.


Determinants of Demand
Price

There is an inverse relationship between price


and quantity demanded. As the graph would
show, when prices rise, the quantity demanded
falls and vice versa
Income

Purchases
. depend on the level of disposable
income that the household is willing to spend.
Tastes and Preferences
Tastes refer to consumers' attitude towards a product:
desire, preferences and opinions for a good or service.

How does “taste” affect demand?

 Favorable change in the consumer preference for a product


would result to increase in demand for that product.

When tastes fall, quantity demanded would decrease.


Prices of related goods or services
Substitute good is one
that can replace the
other good while
complement or
Complementary good
is one that is used
together with the
other good.
Prices of related goods or services
Consumer Expectations
• Expectation refers to a confident belief or
strong hope that a particular event will
happen in the future.

• The consumer expectations on say future


prices, income, and value of economic goods
affect today’s demand for the product or
service.
Number of buyers in the market

As more buyers enter the market rises, so


does the quantity demanded -- even if prices do
not change.
References
Mankiw, G.N., (2012). Essentials of Economics 6th Edition. Harvard
University: South-Western, Cengage Learning
Mastrianna F.V.(2013).Basic Economics 16th Edition. South-Western Cengage
Learning
McConnel, C. et.al (2012). Economics: Principles, Problems, and Policies
(Global Edition). McGraw Hill Co., Inc.
Stock W.A., (2013) Introduction to Economics: Social Issues and Economic
Thinking
http://www.amosweb.com/
http://economics.about.com
https://www.google.com.ph
ph.images.search.yahoo.com
http://www.merriam-webster.com/dictionary
http://www.nscb.gov.ph/
http://useconomy.about.com/
Demand Elasticity and
Its Applications
Learning Objectives

Explain the nature and characteristics of demand


elasticity.
Describe the determinants of demand elasticity.
Calculate and analyze elasticity.
Explain the applications and importance of demand
elasticity.
ELASTIC

capable of ready
change or easy
expansion or
contraction

not rigid or
constricted
ECONOMIC ELASTICITY IN DEFINED
AS …..
The responsiveness of a dependent
economic variable to changes in
influencing factors.
What is Demand Elasticity

Demand elasticity refers to the reaction or the response of


the consumers to changes in determinants of demand such
as:
 Price – Price Demand Elasticity
 Income – Income Elasticity
 Price of related products – Cross Price Elasticity
Types of Demand Elasticity
• Price Elasticity – Buying responses of consumers to
price changes.

•Income Elasticity - Buying responses of consumers when


their incomes change

•Cross Price Elasticity - Buying responses of consumers of


one product when the price of another product changes
Factors Affecting Demand Elasticity
• Availability of Close Substitutes

Substitute goods are goods that can be used in


activities aimed to satisfy the same needs, one in the
place of another.
Factors Affecting Demand Elasticity
Availability of substitute goods:

The larger the number and closer the substitutes available, the
higher the elasticity is likely to be, as people can easily switch from
one good to another if an even minor price change is made. There is
a strong substitution effect.
If no close substitutes are available, the substitution effect will be
small and the demand inelastic.
Factors Affecting Demand Elasticity
• Proportion of Income spent on the product

 The higher the percentage of the consumer's income that the


product's price represents, the higher the elasticity tends to be, as
people will pay more attention when purchasing the good because of
its cost .The income effect is substantial.
 When the goods represent only a negligible portion of the budget
the income effect will be insignificant and demand inelastic.
Factors Affecting Demand Elasticity
 Luxuries and Necessities
 The more necessary a good is, the lower the elasticity, since people
will buy it no matter the price, such as the case of insulin for
diabetics.
Demand for necessary goods increases
as income rises, but at a rate slower than the rate
of increase in income. A normal good for which
the income elasticity of demand is positive but less
than one, hence, inelastic income elasticity.
Factors Affecting Demand Elasticity
• Time horizons
 The product demand is more elastic the longer the time
period . Consumers need time to adjust to changes in prices.

The longer a price change holds, the higher the elasticity is


since consumers find they have the time and inclination to
search for substitutes.
 When fuel prices increase suddenly, consumers may still
fill up their empty tanks in the short run. But when prices
remain high over several years, more consumers will reduce
their demand for fuel by switching to carpooling or public
transportation, or investing in more fuel-efficient vehicles.
Factors Affecting Demand Elasticity
• Brand Loyalty

An attachment to a certain brand—either out of tradition or because


of proprietary barriers—can override sensitivity to price changes,
resulting in more inelastic demand.
Demand Elasticity
Price elasticity
of
Demand
UNITARY ELASTIC
PERFECTLY INELASTIC
Perfectly inelastic means that
quantity demanded is
unaffected by any change in
price. The quantity is
essentially fixed and it does
not matter how much price
changes, quantity does not
budge.
 Perfectly inelastic demand
occurs when buyers have no
choice in the consumption of a
good.
PERFECTLY INELASTIC
In case of necessities such as staple food grains, no
matter how much the price rises or falls, the quantity
demanded by an individual would remain the same -
the consumer will not start eating more if grains
become cheaper nor would he reduce his consumption
if they become dearer.

In case of an increase in the price of such a necessity,


the consumer may cut down on the consumption of
other commodities to adjust his budget such that the
same quantity of food grain is absorbed despite a rise in
price.
Challenge to Students:

Identify and explain the price elasticity of demand as


shown in the above graphs.
Demand Elasticity
income elasticity
of
Demand
Income Elasticity of Demand
Income elasticity of demand measures the
relationship between a change in quantity demanded
for good X and a change in real income. The formula
for calculating income elasticity is:
Income Elasticity of Demand
A commodity is said to have a
perfectly inelastic demand if the
quantity demanded or consumed
of it does not respond to a
change in the income of the
consumer.

Such commodities are usually


known as sticky goods and consist
mainly of necessities.
Income Elasticity of Demand
Income Elasticity of Demand
Normal goods have a positive income elasticity of demand so as
consumers' income rises more is demanded at each price i.e. there is an
outward shift of the demand curve.

Normal necessities have an income elasticity of demand of between 0


and +1 for example, if income increases by 10% and the demand for
fresh fruit increases by 4% then the income elasticity is +0.4. Demand is
rising less than proportionately to income

Luxury goods and services have an income elasticity of demand >


+1 i.e. demand rises more than proportionate to a change in income –
for example a 8% increase in income might lead to a 10% rise in the
demand for new kitchens. The income elasticity of demand in this
example is +1.25.
Income Elasticity of Demand
Inferior goods have a negative income
elasticity of demand meaning that demand
falls as income rises.

Inferior goods or services exist


where superior goods are available if the
consumer has the money to be able to buy it.
Demand Elasticity
CROSS PRICE ELASTICTY
Formula for Cross Price Elasticity
Cross Price Elasticity
Cross Price Elasticity
Cross Price Elasticity

Substitutes or
Complementary? Explain
your answer using the
cross price elasticity
concept.
APPLICATIONS
of
DEMAND ELATICITY
ELASTICITY AND TOTAL REVENUE
ELASTICITY AND TOTAL REVENUE
ELASTICITY AND TOTAL REVENUE
ELASTICITY AND TOTAL REVENUE
Income Elasticity and Sales

 Luxury products with high-income elasticity


see greater sales volatility over the business cycle
than necessities where demand from consumers
is less sensitive to changes in the cycle.
ELASTICITY AND MARKET PRICE
REFERENCES
Mankiw, G.N., (2012). Essentials of Economics 6th Edition. Harvard University: South-
Western, Cengage Learning
Mastrianna F.V.(2013).Basic Economics 16th Edition. South-Western Cengage Learning
McConnel, C. et.al (2012). Economics: Principles, Problems, and Policies (Global Edition).
McGraw Hill Co., Inc.
Paraiso O.C. et.al (2011). Introduction to Microeconomics, Mutya Publishing House,
Inc.
Stock W.A., (2013) Introduction to Economics: Social Issues and Economic Thinking

Web Sites:
http://www.amosweb.com
http://beta.tutor2u.net/economics/
http://www.buzzle.com/
http://economicswebinstitute.org
https://ph.images.search.yahoo.com
http://www.merriam-webster.com
http://en.wikipedia.org/
Elasticity and Its Application

3
Elasticity and its Application

The determinants of supply and demand were discussed in the previous chapter. Consumers and
suppliers react differently according to the changes in prices of commodities and the related
products and services. The concept, measurement, application, and importance of economic
elasticity will be discussed in this chapter.

Objectives:

After studying this chapter, the students should be able to:

1. Explain the nature and characteristics of demand and supply elasticity


2. Describe the determinants of demand and supply elasticity
3. Calculate and analyze elasticity
4. Explain the applications and importance of elasticity

What is Elasticity?

Economic elasticity is defined as the responsiveness of a dependent economic variable to


changes in influencing factors, such as price, income and price of related products. It is a
measure of responsiveness between any two variables.

I. Elasticity of Demand

Demand elasticity refers to the reaction or the response of the consumers to changes in
determinants of demand such as price, income and price of related products. As discussed
earlier, when price of commodities increases, the logical behavior of the consumer is to decrease
consumption. However, the degree of reaction varies from one consumer to another, considering
our varying values and preferences.

Principles of Economics, Taxation and Agrarian Reform 1


Elasticity and Its Application

A. Factors Affecting Demand Elasticity

1. Availability of Close Substitutes

Substitute goods are goods that can be used in activities aiming to satisfy the same
needs, one in the place of another. Considering other factors constant, the consumer
substitution effect showed that there is an inverse relationship between quantity
demanded and price.

The larger the number and closer the substitutes available, the higher the elasticity is
likely to be, as people can easily switch from one good to another if an even minor
price change is made. There is a strong substitution effect. Substitutes can be
classified as close substitutes, when there is a high cross elasticity of demand.

For example, there are many powdered laundry detergent in the market that it is easy
for the consumers to look for a substitute of initially preferred detergent when there is
an upward price adjustment for said detergent.

If no close substitutes are available, the substitution effect will be small and the
demand will be inelastic. If goods are weak substitutes, there will be a low cross
elasticity of demand. In baking, you cannot replace egg with another commodity
hence, the demand is inelastic.

2. Proportion of income spent on the product

The higher the percentage of the consumer's income that the product's price
represents, the higher the elasticity tends to be, as people will pay more attention on
the price when purchasing the good. The income effect is substantial.

Rent and education are big-ticket items in our list of expenditures, that any price
adjustment would affect your income.

On the other hand, when the goods represent only a negligible portion of the budget,
the income effect will be insignificant and demand inelastic. The increasing cost of
writing pens and pencils will be taken for granted by students, since it does not eat up
a sizeable portion of one’s allowance.

3. Importance of the product to the buyer: Luxuries and Necessities

Necessities are commodities that we need to survive like food water and food while
luxuries are those that will make our life more comfortable. However, without the
latter, we can still continue to survive. The more necessary a good is, the lower the
elasticity, since people will buy it no matter the price, such as the case of insulin for
diabetics.

Principles of Economics, Taxation and Agrarian Reform 2


Elasticity and Its Application

Demand for necessary goods increases as income rises, but at a rate slower than the
rate of increase in income. A normal good in which the income elasticity of demand
is positive but less than one is considered inelastic income elasticity.

It should be emphasized that the classification of commodities into luxury or


necessities differs from one person to another. What is luxury to one can be a
necessity to the other.

Car is a necessity for the marketing man in the city who needs to acts fast and
manages his time well to meet clients while it is a luxury for a farmer tending to his
crops on the countryside.

4. Time horizons

The product demand is more elastic the longer the time period. Consumers need time
to adjust to changes in prices. The longer a price change holds, the higher the
elasticity is, since consumers find they have the time and inclination to search for
substitutes.

When fuel prices increase suddenly, consumers may still fill up their empty tanks in
the short run. But when prices remain high over several years, more consumers will
reduce their demand for fuel by switching to carpooling or public transportation, or
investing in more fuel-efficient vehicles.

5. Brand Loyalty and Habit

Brand loyalty occurs when consumers have a strong preference for a particular type
of good or brand and are willing to make repeat purchases. Preference for a certain
brand can override sensitivity to price changes, resulting in more inelastic demand.

6. Postponement of consumption

The demand for the consumption of goods which can be deferred for some time is
elastic such as the demand for appliances which can be postponed for some time if
there is not enough budget or if prices rate higher. However, the demand for
necessaries like baby’s milk is inelastic because its use cannot be deferred.

7. Joint demand

There are goods that are being jointly demanded such as car and gasoline. The
elasticity of demand of the second good depends on the elasticity of demand of the
main good. In our example if the demand for car is inelastic, the demand for gasoline
will also be inelastic.

Principles of Economics, Taxation and Agrarian Reform 3


Elasticity and Its Application

B. Classification of Demand Elasticity

1. Elastic demand – demand is elastic if the percentage change in the price results in a
larger percentage change in the quantity demanded.

2. Perfectly elastic demand – the extreme subcategory of elastic demand wherein the
quantity demanded changes by an infinite amount in response to a price change
resulting to a horizontal demand curve.

3. Inelastic demand – when the percentage change in the quantity demanded is lower
than the percentage change in the price, we say that demand is inelastic.

4. Perfectly inelastic demand - the extreme category of inelastic demand where the
quantity demanded does not change in response to a price change resulting to a
vertical demand curve.

5. Unitary elastic – when the percentage change in the price results to an equal
percentage change in the quantity demanded.

Summary of Elasticity Coefficient Values


Category Relationship Between Elasticity Coefficient
∆Qd and ∆P
Elastic Demand │% ∆Qd│>│% ∆P│ │E│>1

Inelastic Demand │% ∆Qd│< │% ∆P│ │E│< 1

Unitary Elastic │% ∆Qd│=│% ∆P│ │E│= 1

Perfectly Elastic │% ∆P│ = 0 │E│= ∞

Perfectly Inelastic │% ∆Qd│= 0 │E│=0

Principles of Economics, Taxation and Agrarian Reform 4


Elasticity and Its Application

C. Computation of Demand Elasticity

Elasticity Coefficient

The elasticity coefficient is the percentage change in quantity demanded divided by the
percentage change in price. The elasticity coefficient gives us a measure of the consumers’
response to a one (1) percent change in the price of the product. We also use this to identify
the type of demand elasticity. It should be emphasized that we are comparing the degree of
consumer response with the change in price and not whether the change is positive and
negative, hence we consider the absolute value. Vertical bars are placed around numbers to
indicate absolute value. The formula for elasticity coefficient is:

Percentage change in Quantity Demanded


Elasticity Coefficient = Percentage Change in Price

│E│ = %∆Qd
%∆P

│E│ =Q2 - Q1
Q1_______
P2 - P1
P1
Where │E│= elasticity coefficient
∆ = Delta Symbol for “change in”
Q1 = (Old) Quantity demanded before the price change
Q2 = (New) Quantity demanded in response to the price change
P1 = Old or previous Price
P2 = New or Current Price
Application:

At P38.00/kilogram selling price for rice, daily sales of the rice retailers in Barangay Sta. Clara
totals to 1,500 kilograms. At the onset of the lean months, the market price for rice increased to
P40.00/kg, resulting to a decrease in demand for rice now posted at 1,450 kilograms. Given this
scenario, determine the elasticity coefficient.

│E│ = 1,450 – 1,500


____1,500___
40-38____
38

│E│ = - 0.03
0.05
│E│ = - 0.60 = │0.60│< 1 , inelastic

D. Types of Demand Elasticity

Principles of Economics, Taxation and Agrarian Reform 5


Elasticity and Its Application

D.1 Price Elasticity of Demand

Price elasticity of demand is a measure of the degree by which consumers adjust the
quantity of some products they purchase to a change in the price of said product. It is the
ratio of the percentage change in the quantity demanded to the percentage change in its
price. Other than computing for the elasticity coefficient, we can identify the different
types of price demand elasticity through graphs:

Elastic demand Inelastic demand

Below is a summary of the characteristics and features of the price elasticity of demand:

Principles of Economics, Taxation and Agrarian Reform 6


Elasticity and Its Application

D.2. Income Elasticity of Demand

Income elasticity of demand measures the relationship between a change in quantity demanded
for good X and a change in real income or the buying responses of consumers when their
incomes change. The formula for calculating income elasticity is:

Principles of Economics, Taxation and Agrarian Reform 7


Elasticity and Its Application

It can be noted that the formula is similar to that of price elasticity of demand, except that the
determinant of consumption is income. Further, the negative and positive signs matter when you
are computing for the income elasticity of demand. The sign and the number provide different
information about the relationship between income and demand.

Normal goods have a positive income elasticity of demand which means an increase in income
causes an increase in demand. For normal necessities, income elasticity of demand is positive
but less than 1.

A luxury good means that an increase in income causes a bigger percentage increase in
demand. It means that the income elasticity of demand is greater than one. When income rises,
people spend a higher percentage of their income on the luxury good. It should be noted that a
luxury good is also a normal good, but a normal good is not necessarily a luxury good.

Inferior goods have a negative income elasticity of demand meaning that demand falls as
income rises. Inferior goods or services exist where superior goods are available if the consumer
has the money to be able to buy it.

The table below provides us a listing of some goods and services, the consumption of which is
greatly affected by the level of income.

Principles of Economics, Taxation and Agrarian Reform 8


Elasticity and Its Application

We cannot draw a market demand curve of normal goods and inferior goods, because what is
normal good for one may be an inferior good for the other and vice-versa. Suffice it to say that
normal goods and inferior goods are associated with the income of consumer: when
income rises, demand for normal goods rises and vice-versa. On the other hand, demand for
inferior goods falls with an increase in income.

The Engel’s Curves


Income elasticity of demand can also be illustrated by Engel curves, named after 19th Century
German statistician Ernst Engel, showing the relationship between consumer demand and
household income. People spend smaller portion of their income on food as their income
increases.

Engel curves for normal goods slope upwards – the flatter the slope the more luxurious the good,
and the greater the income elasticity. In contrast, Engel curves for inferior goods have a negative
slope.

Engel Curves

Principles of Economics, Taxation and Agrarian Reform 9


Elasticity and Its Application

The Engel’s curves above show the demand for the three goods and each responds differently to
the same change in income, increasing from Y to Y1. Demand for the normal good increases
from Q to Q1, demand for the luxury good rises much more to Q2, and demand for the inferior
good falls from Q to Q3.

As shown by the graph below, on the national scale, the demand for normal goods increases
during the prosperity phase when incomes are higher. In times of recession and depression,
where jobs are limited or not available, income is limited while demand for inferior goods
increases.

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Elasticity and Its Application

D.3. Cross Price Elasticity of Demand

The cross price elasticity of demand measures how much the quantity demanded of one good
responds to changes in the price of another good. We calculate the coefficient of the cross price
elasticity of demand using the following formula:
Percentage change in quantity
Cross price demanded of product A_______
elasticity of demand = Percentage change in price
of other product B

or

As is income elasticity of demand, negative and positive sign matters and they indicate the
relationship between Product A and Product B as shown below:

Principles of Economics, Taxation and Agrarian Reform 11


Elasticity and Its Application

For easy recall, the table below guides us on how to differentiate complements and substitutes
taking into account the effect of the changing price of one on the demand of the other product.
When the cross price elasticity of demand for products equals to zero, this indicates that they
are unrelated.

Furthermore, the relationship between products and services can also be easily identified using
graphical representation.

Principles of Economics, Taxation and Agrarian Reform 12


Elasticity and Its Application

The diagram below gives a summary on the concept of price elasticity of demand:

II. SUPPLY ELASTICITY

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Elasticity and Its Application

Price Elasticity of Supply

The price elasticity of supply is the percentage change in quantity supplied divided by the
percentage change in price. Formula for computing supply elasticity is the same as that for the
price elasticity of demand, except quantity supplied rather than quantity demanded is used.

The supply curve is upward sloping because of the direct relationship between price and
quantity. Hence, the price elasticity of supply has a positive sign.

A. Factors Affecting Supply Elasticity

1. The number of producers – The more producers there are, the easier it should be
for the industry to increase output in response to a price increase. Supply will thus
be more elastic.

2. Spare or excess capacity – Spare capacity means that production can be stepped
up in the short run when there is a rise in market demand. The more capacity there
is in the industry, the easier it should be to increase output if price goes up. This
makes supply more elastic.

3. Ease of storing stocks - if it is easy to stock goods, then when the price rises, the
firm can sell these stocks, making supply more elastic. In the case of goods such
as fresh products, it may not be easy to store them and so the supply will not be
very flexible.

4. Inventory - A producer with a large number of products can quickly increase the
amount of supply it delivers to the market.

Principles of Economics, Taxation and Agrarian Reform 14


Elasticity and Its Application

5. The time period -- Over time, the firm can invest in training resulting to more
equipment and more firms joining the industry. This would mean that supply
should be more flexible and more elastic.

6. Factor mobility or availability of materials - the easier it is for resources to move


into the industry, the more elastic supply will be. On the other hand, the limited
availability of materials could limit the production, making it an inelastic supply.

7. Length of the production period - the quicker production of the good is, the easier
it will be to respond to a change in price. Supply in manufacturing is usually more
price elastic than agriculture.

8. Product type – if the product is complex to manufacture, it takes time to produce


and becomes more inelastic.

Knowing the factors that affect the supply elasticity, and a high price elasticity of supply is
deemed desirable, firms need to undertake the following courses of actions that may improve the
ability to respond immediately to changes in market conditions:

Principles of Economics, Taxation and Agrarian Reform 15


Elasticity and Its Application

1. Creating spare capacity


2. Using the latest technology
3. Keeping sufficient stocks
4. Developing better storage systems
5. Prolonging the shelf life of products
6. Developing better distribution systems
7. Providing training for workers
8. Having flexible workers who can do a range of jobs
9. Locating production near to the market
10. Allowing inward migration of labor if there is a labor shortage

B. Classification of Supply Elasticity

1. Elastic supply – supply is elastic if the percentage change in the price results in a
larger percentage change in the quantity supplied. This means producers can react
immediately to change in price.

2. Perfectly elastic supply – the extreme subcategory of elastic supply wherein the
quantity supplied changes by an infinite amount in response to a price change
resulting to a horizontal supply curve.

3. Inelastic supply – when the percentage change in the quantity supplied is lower
than the percentage change in the price, we can say that supply is inelastic. This
means producers have weak response to price change. Farmers cannot react
immediately to price change since it takes sometimes for production of
agricultural products such as rice and corn.

4. Perfectly inelastic supply - the extreme category of inelastic supply where the
quantity supplied does not change in response to a price change resulting to a
vertical supply curve.

5. Unitary elastic – when the percentage change in the price results to an equal
percentage change in the quantity supplied.

Summary of Elasticity Coefficient Values


Category Relationship Between Elasticity Coefficient
∆Qs and ∆P
Elastic Supply │% ∆ Qs │>│% ∆P│ │E│>1

Inelastic Supply │% ∆ Qs │< │% ∆P│ │E│< 1

Principles of Economics, Taxation and Agrarian Reform 16


Elasticity and Its Application

Unitary Elastic │% ∆ Qs │=│% ∆P│ │E│= 1

Perfectly Elastic │% ∆P│ = 0 │E│= ∞

Perfectly Inelastic │% ∆Qd│= 0 │E│=0

C. Graphical Representation of Supply Elasticity

Price elasticity of supply is a measure of the degree by which suppliers and producers
respond to a change in the price of a product. It is the ratio of the percentage change in
the quantity supplied to the percentage change in its price. Other than computing for the
elasticity coefficient, we can identify the different types of price supply elasticity through
graphs:

Principles of Economics, Taxation and Agrarian Reform 17


Elasticity and Its Application

III. Application of Elasticity

1. Price Elasticity of Demand and Total Revenue

Price elasticity of demand and total revenue both deal with price and demand. Price
elasticity measures the consumers’ response to changes in price while total revenue is
calculated by multiplying the quantity of goods sold (demand) by its price. The goal of
any business is to maximize profit and/or to increase revenue by selling more products
or by increasing the price. Equally important is the knowledge of the price elasticity of
demand.

2. Wage Determination

A price reduction for products with elastic demand will result to an increase in
quantity demanded. This means additional sales and profit. In result to this, the total
revenue will also increase. This will enable producers to implement a wage hike for its
workers.

3. Farm Production Guide

Agricultural products like rice, corn, and sugar have inelastic demand, meaning that the
quantity demanded does not change much even if there is a big increase or decrease in
price. In a surplus situation, the price of said products decreases, negatively affecting
the revenue of the farmers. This is paradox of poverty amidst plenty. To protect the
interest of the farmers and to assure them of income from their produce, measures are
being done to control production and maintain price stability like setting of minimum
price or support price.

Principles of Economics, Taxation and Agrarian Reform 18


Elasticity and Its Application

4. Imposition of Taxes

Tax is one of the sources of government budget. However, what to tax and the tax rate
determination need thorough planning and deliberation. Tax increases the production
cost and is totally or partially passed on to the consumers through an upward
adjustment in the price of the product. Levying additional taxes on products with high
elastic demand might defeat the purpose of increasing revenue for the government. A
percentage increase in price will create a higher percentage reduction in the quantity
demanded of the product.

5. Income Elasticity and Sales

Businesses evaluate income elasticity of demand for various products to help predict
the impact of a business cycle of product sales. Luxury products with high income
elasticity see greater sales volatility over the business cycle than necessities where
demand from consumers is less sensitive to changes in the cycle.

6. Cross Price Elasticity of Demand and Pricing

This concept is considered in pricing decisions for products with substitutes and
complements. Product interdependence can also be measured using the cross price
elasticity. Companies and manufacturing firms which produce different product types
can determine the effect of changing the price of one product to the demand of other
products.

Principles of Economics, Taxation and Agrarian Reform 19


Elasticity and Its Application

References:
Mankiw, G.N., (2012). Essentials of Economics 6th Edition. Harvard University: South-Western,
Cengage Learning

Mastrianna, F.V., (2013). Basic Economics 16th Edition. South-Western Cengage Learning

McConnel, C., et.al (2012). Economics: Principles, Problems, and Policies (Global Edition).
McGraw Hill Co., Inc.

Paraiso, O.C., et.al (2011). Introduction to Microeconomics, Mutya Publishing House, Inc.

Stock W.A., (2013) Introduction to Economics: Social Issues

http://www.amosweb.com
http://beta.tutor2u.net/economics
http://www.buzzle.com/
http://www.economicshelp.org/
https://www.google.com.ph
http://economicswebinstitute.org
http://www.economicsonline.co.uk/
http://faculty.ses.wsu.edu/
https://ph.images.search.yahoo.com
http://www.merriam-webster.com
http://www.preservearticles.com/
http://en.wikipedia.org/

Principles of Economics, Taxation and Agrarian Reform 20


THEORY OF CONSUMER’S BEHAVIOR
Learning Objectives
• Define and explain the relationship
between total utility and marginal utility

• Explain the law of diminishing marginal


utility

• Demonstrate an understanding and


significance of the concept of Indifference
Curve
“how consumers allocate their money
incomes among goods and services.”
Consumer Behavior
Assumptions
Rational behavior
get "the most for their money" or, to maximize their
total utility.

Preferences –
consumer has different tastes and preferences

Budget Constraint
Every consumer faces a budget constraint
There is infinite demand, but limited income

Prices:
Goods are scarce because of the demand for them.
Kotler’s Buyer Behavior
Maslow’s Hierarchy of Needs
Utility Defined
• Utility is the capacity of a commodity or
service to satisfy some human wants
• Total utility refers to the aggregate level of
satisfaction or fulfillment that a consumer
receives through the consumption of a
specific good or service.
• Summing up all the marginal utilities of the
individual units would give us the total
utilities.
Marginal Utility
• The additional satisfaction a consumer
gains from consuming one more unit of a
good or service.
• Positive marginal utility is when the
consumption of an additional item
increases the total utility.
• Negative marginal utility is when the
consumption of an additional item
decreases the total utility.
Marginal Utility
As a person consumes more and more units of a
commodity:
 the marginal utility of the additional units begins to
diminish
 the total utility goes on increasing at a diminishing rate.
Marginal Utility
• When the marginal utility comes to zero or we say the
point of satiety is reached, the total utility is the
maximum.

• If consumption is increased further from this point of


satiety, the marginal utility becomes negative and total
utility begins to diminish.
The relationship between total utility and marginal
utility shown by the following schedule.
Table 4.1:
Utility Schedules
TOTAL MARGINAL TU = f (Q)
UNIT UTILITY UTILITY
MU = ∆TU
1 20 20 ∆MU
2 38 18
3 54 16 Where:
4 68 14 TU = Total
5 78 10 f= is an function of
6 82 4 MU= Marginal Utility
Q= units of consumption
7 82 0 ∆ = infinitesimal change
8 77 -5
9 70 -7
10 65 -5
Diminishing Marginal Utility
Point of Satiety

The graphical representation of Table 4.1 showing positive


and negative marginal utility. It can be noted that the
maximum consumption is only up to the point of the
maximum utility.
Indifference Curve Analysis
• An indifference curve is a locus of points,
each of which represents a combination in
the consumption of commodities that
yield equal level of consumer satisfaction
CHARACTERISTICS OF
INDIFFERENCE CURVE
1) Indifference Curves are Negatively Sloped:

The indifference curves


must slope downward
from left to right. As the
consumer increases the
consumption of X
commodity, he has to give
up certain units of Y
commodity in order to
maintain the same level of
satisfaction.
(2) Higher Indifference Curve Represents Higher
Level of Satisfaction

Indifference curve that lies


above and to the right of
another indifference curve
represents a higher level of
satisfaction.

The combination of goods


which lies on a higher
indifference curve will be
preferred by a consumer to
the combination which lies on
a lower indifference curve.
(3) Indifference Curves are Convex to the Origin:

The Marginal Rate of


Substitution is the rate at which
the consumer must sacrifice
units of one commodity to obtain
one more unit of another
commodity

The Slope of the curve is


referred as the Marginal Rate of
Substitution.
(4) Indifference Curves cannot Intersect Each Other

It is because at the point of


tangency, the higher curve will
give as much as of the two
commodities as is given by the
lower indifference curve.
(5) Indifference Curves do not Touch the Horizontal or Vertical Axis:

One of the basic assumptions of


indifference curves is that the
consumer purchases
combinations of different
commodities, hence indifference
curve will not touch any of axis.
References
Liquigan R.M., (2010). Basic Economics with Agrarian Reform and Taxation, Mega-Jestra
Prints, Inc.
Mankiw, G.N., (2012). Essentials of Economics 6th Edition. Harvard University: South-
Western, Cengage Learning
McConnel, C. et.al (2012). Economics: Principles, Problems, and Policies (Global Edition).
McGraw Hill Co., Inc.
Paraiso O.C. et.al (2011). Introduction to Microeconomics, Mutya Publishing House, Inc.

Internet Web Sites:

http://dictionary.reference.com/
https://ph.images.search.yahoo.com
http://www.investopedia.com/
http://wikieducator.org/
Theory of Consumer Behavior

4
Theory of Consumer Behavior

A consumer is a person or group of people who are the final users of products and/or services
generated within a social system. A consumer is an individual who buys products and service for
personal use and not for manufacture or resale. Consumers play an important role in the
economy. Consumer demand is a motivating factor for businesses and producers to produce and
sell. Consumer behavior refers to how consumers allocate their money income among goods and
services.

Objectives:

After studying this chapter, the students should be able to:

1. Define and explain the relationship between total utility and marginal utility
2. Explain the law of diminishing marginal utility
3. Demonstrate an understanding and significance of the concept of indifference curve
4. Explain the characteristics of indifference curve

I. Definition of Consumer Behavior

Consumer Behavior

Consumer behavior is the study of individuals, groups, or organizations and the processes they
use to select, secure, use, and dispose of products, services, experiences, or ideas to satisfy needs

Principles of Economics, Taxation and Agrarian Reform 1


Theory of Consumer Behavior

as well as the impacts that these processes have on the consumer and society. It studies
characteristics of individual consumers such as demographics and behavioral variables in an
attempt to understand people's wants and tries to assess influences on the consumer from groups
such as family, friends, sports, reference groups, and society in general.

II. Concept of Utility

William Stanley Jevons


(1 September 1835 – 13 August 1882)
English Economist and Logician

The first economist to introduce the concept of utility in economics is W.S. Jevrons who
defined utility as “the basis on which the demand of an individual for a commodity depends
upon.”

Utility is also defined as “the power of a commodity or service to satisfy human want.” It
refers to the satisfaction which is derived by the consumer by consuming the goods. It
should be emphasized that utility is subjective and differs from one person to another.
Utility is a subjective satisfaction which the consumer gets from consuming any good or
service.

2 Principles of Economics, Taxation and Agrarian Reform


Theory of Consumer Behavior

III. Approaches in Measuring Utility

In economics, utility simply refers to the satisfaction that a consumer gets from goods and
services. Utility affects decision-making and product choice. As had been mentioned, utility
for the same product or service varies among consumers.

Qualitative concept such as utility is difficult to measure. However, to provide foundation for
a better understanding of consumer behavior, economists try to quantify it in two different
ways: cardinal utility and ordinal utility.

A. Cardinal Utility/Diminishing Marginal Utility

Cardinal utility is the assignment of a numerical value to utility in terms of the


theoretical unit of utility, the util. Cardinal utility analysis takes into account the
following assumptions:

a. Rationality. The consumer is rational and he seeks to maximize


satisfaction from his limited disposal income.

b. Utility is cardinally measurable. The utility can be measured in


cardinal numbers such as 1, 3, 5, 10, 15, 18, etc.

c. Marginal utility of money remains constant. Another important


premise of cardinal utility is that money spent on the purchase of a
good or service should remain constant.

d. Diminishing marginal utility. It is also assumed that the marginal


utility obtained from the consumption of a good diminishes
continuously as its consumption is increased.

e. Independent utilities. The utility which is derived from the


consumption of a good is a function of the quantity of that good alone
and does not depend at all upon the quantity consumed of other goods.

f. Introspection method. It is assumed that the behavior of marginal


utility in the mind of another person can be judged with the help of self
observation.

Principles of Economics, Taxation and Agrarian Reform 3


Theory of Consumer Behavior

III. A.1: Difference between Total Utility and Marginal Utility:

Total utility refers to the aggregate level of satisfaction or fulfillment that a consumer
receives through the consumption of a specific good or service over a period of time.
Summing up all the marginal utilities (MU) of the individual units would give us the total
utilities. Hence, the formula for total utility (TU) is TUx = ∑MU.

Marginal utility means an additional or incremental utility. Marginal utility is the


change in the total utility that results from one unit change in consumption of the
commodity within a given period of time. It is the difference between total utility derived
from one level of consumption and total utility derived from another level of
consumption. This can be computed using the formula: MU = ∆TU
∆Q

The relationship between total utility and marginal utility is shown by the following
schedule:

Table 4.1: Utility Schedule

TOTAL MARGINAL
UNIT UTILITY UTILITY
1 20 20
2 38 18
3 54 16
4 68 14
5 78 10
6 82 4
7 82 0
8 77 -5
9 70 -7
10 65 -5

It may be noted that as a person consumes more and more units of a commodity, the
marginal utility of the additional units begins to diminish but the total utility goes on
increasing at a diminishing rate.

Positive marginal utility is when the consumption of an additional item increases the total
utility. Negative marginal utility, on the other hand, is when the consumption of an
additional item decreases the total utility.

4 Principles of Economics, Taxation and Agrarian Reform


Theory of Consumer Behavior

When the marginal utility comes to zero or when the point of satiety is reached, the total
utility is the maximum. If consumption is increased further from this point of satiety, the
marginal utility becomes negative and total utility begins to diminish.

The relationship between total utility and marginal utility is further explained using the
graphical representation below:

Diminishing Marginal Utility

Total/Marginal Utility Point of Satiety

Units

 The total utility curve starts at the origin as zero consumption of a certain commodity
yields zero utility.

 The TU curve reaches at its maximum or a peak at “82” when MU is zero.

 The MU curve falls through the graph. A special point occurs when the consumer
consumes the “7th” commodity. He gains no marginal utility from it. This is the point of
satiety and after this point, marginal utility becomes negative.

Principles of Economics, Taxation and Agrarian Reform 5


Theory of Consumer Behavior

Based on earlier discussions and the graph, cardinal utility is related to the law of diminishing
marginal utility which states that at a certain point, every extra unit of a good will provide less
and less utility. This law explains the natural tendency of consumers wherein more and more
units of a specific commodity is consumed, the utility from the successive units goes on
diminishing.

Hermann Heinrich Gossen


(7 September 1810 – 13 February 1858)

Mr. H. Gossen, a German economist, was first to explain this law in 1854. Alfred
Marshal, later on, restated this law. He said that this law is “the additional benefit which a
person derives from an increase of his stock of a thing diminishes with every increase in the
stock that already has.”

The law of diminishing marginal utility is based upon three facts:

1. Total wants of a man are unlimited but each single want can be satisfied. As a man gets
more and more units of a commodity, the desire of his for that good goes on falling. A
point is reached when the consumer no longer wants any more units of that good.

2. Different goods are not perfect substitutes for each other in the satisfaction of various
particular wants. As such, the marginal utility will decline as the consumer gets
additional units of a specific good.

3. The marginal utility of money is constant given the consumer’s wealth.

6 Principles of Economics, Taxation and Agrarian Reform


Theory of Consumer Behavior

Curve/Diagram of Law of Diminishing Marginal Utility

Marginal Utility
25
Initial Utility
20

15

10
Point of
5 Satiety
0

-5 1 2 3 4 5 6 7 8 9 10

-10

III.A.2: Assumptions of Law of Diminishing Marginal Utility

a. Rationality: The consumer is rational and aims at maximization of utility, subject


to availability of his income.

b. Constant marginal utility of money: The marginal utility of money based for
purchasing goods remains constant. If the marginal utility of money changes with
the increase or decrease in income, then it cannot yield correct measurement of
the marginal utility of the good.

c. Diminishing marginal utility: The utility gained from the successive units of a
commodity diminishes in a given time period.

d. Utility is additive: The utilities of different commodities are independent and the
utility of each commodity is additive.

e. Consumption to be continuous: Consumption of a commodity should be


continuous for the law to be effective.

f. Suitable quantity: Commodity consumed is taken in suitable and reasonable


units. If the units are too small, then the marginal utility, instead of falling, may
increase up to a few units.

g. Character of the consumer does not change: The law holds true if there is no
change in the character of the consumer.

Principles of Economics, Taxation and Agrarian Reform 7


Theory of Consumer Behavior

h. No change to fashion, customs and tastes: If there is a sudden change in fashion


or customs or taste of a consumer, then it can make the law inoperative.

i. No change in the price of the commodity: As more units are consumed, there
should never be changes in the price of the commodity.

III.A.3: Importance of Law of Diminishing Marginal Utility

1. Basis of the law of demand

The consumer buys the goods if the marginal utility of the commodity is higher than its
price. Buying additional units successively would diminish its utility. Hence, he pays a
lesser amount or reduced demand. To induce or to encourage consumers to buy large
quantity of the commodity, its price should be lowered.

2. Consumer’s surplus concept

Consumer surplus is an economic measure of consumer satisfaction, which is calculated


by analyzing the difference between what consumers are willing to pay for a good or
service relative to its market price. A consumer surplus occurs when the consumer is
willing to pay more for a given product than the current market price. A consumer, while
purchasing the commodity, compares the utility of the commodity with that of the price
which he has to pay.

3. Importance to the consumer

To get the maximum satisfaction from limited resources, the consumer allocates his
income on commodities and services in such a way that the marginal utility from all the
uses are the same. The concept of marginal utility helps the consumer in arranging his
scale of preference for the commodities and services.

4. Importance to government policy determination

As a person collects money, the desire to accumulate more money increases, but as he
gets more and more wealth, its utility progressively decreases, though it does not reach to
zero. The progressive system of taxation, where tax increases as the tax base increases, is
based on the law of diminishing marginal utility.

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Theory of Consumer Behavior

B. Ordinal Utility/Indifference Curve Analysis

There were some critics of the concept of cardinal utility and one of them was Vilfredo
Pareto, an Italian engineer, sociologist, economist, political scientist, and philosopher.

Vilfredo Pareto
(15 July 1848 – 19 August 1923)

Pareto was the first to recognize that cardinal utility could be dispensed with and stated
that utility is neither quantifiable nor addible. He suggested that the concept of utility
should be replaced by the scale of preference.

Relative to this, Sir John Richard Hicks and Sir Roy George Douglas Allen introduced
the technique of indifference curves. The cardinal utility approach is thus replaced by
ordinal utility theory.

Sir John Richard Hicks Sir Roy George Douglas Allen


(8 April 1904 – 20 May 1989) (3 June 1906 – 29 September 1983)

Principles of Economics, Taxation and Agrarian Reform 9


Theory of Consumer Behavior

Proponents of the theory of ordinal utility believed that this is a better way of determining
consumer satisfaction because it simply denotes consumer preferences without assigning them
numerical values.

III.B.1: Definition and Explanation

An indifference curve shows all the various combinations of two goods that give an equal
amount of satisfaction to a consumer. The indifference curve analysis approach was developed
by J.R. Hicks and R.G.D. Allen in the year 1928. Both viewed utility as purely subjective and
immeasurable.

III.B.2: Assumptions of the Ordinal Utility Theory


1. Rational behavior of the consumer: Individuals are rational in making
decisions from their expenditures on consumer goods.

2. Utility is ordinal: Utility cannot be measured cardinally, but consumer


can rank the goods according to the utility or satisfaction level.

3. Diminishing marginal rate of substitution: In the indifference curve


analysis, the principle of diminishing marginal rate of substitution is
assumed.

4. Consistency in choice: The consumer preference, during another period


of time does not change.

5. Goods consumed are substitutable: The goods consumed by the


consumer are substitutable.

An indifference curve is a locus of points, each of which represents a combination in the


consumption of commodities that yield equal level of consumer satisfaction. Consumer A
likes banana and biscuit and he can consume them both in various combinations as shown
below. Any combinations will give him the same total amount of satisfaction.

Indiferrence Schedule

Combination Biscuits Bananas


1 1 12
2 2 8
3 3 5
4 4 3
5 5 2

10 Principles of Economics, Taxation and Agrarian Reform


Theory of Consumer Behavior

III.B.3: Diagram of Indifference Curve and Indifference Map


Graphing the different combinations of bananas and biscuits preferred by Consumer A would
result to the following indifference curve. As can be observed, the indifference curve does not
give numbers of utils or satisfaction levels. It only shows the combinations of bananas and
biscuits that Consumer A views as being equally satisfactory.

An Indifference Map

Drawing more than one indifference curve in one diagram would give us an indifference map.
Each successive curve farther from the point of origin or from the original curve indicates a
higher level of satisfaction.

Based on the above indifference map, say let us keep the consumption of bananas at constant 6
pieces and make adjustments on the biscuits, gives us the following combinations:
IC1 = (2, 6) IC2 = (2.75, 6) IC3 = (3.25, 6)
It can be observed that the consumption of “biscuits” increases as we move from IC1<IC2<IC3
resulting to higher consumer satisfaction.

Principles of Economics, Taxation and Agrarian Reform 11


Theory of Consumer Behavior

IV.B.4: Characteristics of Indifference Curve

1) Indifference Curves are Negatively Sloped


The indifference curves must slope downward from left to right. As the consumer
increases the consumption of X commodity, he has to give up certain units of Y
commodity in order to maintain the same level of satisfaction.

2) Higher Indifference Curve Represents Higher Level of Satisfaction


Indifference curve that lies above and to the right of another indifference curve
represents a higher level of satisfaction. The combination of goods which lies on a
higher indifference curve will be preferred by a consumer to the combination
which lies on a lower indifference curve.

12 Principles of Economics, Taxation and Agrarian Reform


Theory of Consumer Behavior

(3) Indifference Curves are Convex to the Origin

The Marginal Rate of Substitution is the rate at which the consumer must
sacrifice units of one commodity to obtain one more unit of another
commodity. The slope of the curve is referred as the Marginal Rate of
Substitution.

The concept of marginal rate substitution (MRS) was introduced by Dr. J.R.
Hicks and Prof. R.G.D. Allen in lieu of the cardinal utility’s diminishing
marginal utility. The two economists shared the opinion that it is unnecessary
to measure the utility of a commodity but rather to look into the consumer’s
preference of one commodity to another and get the same level of satisfaction.
The rate or ratio at which goods X and Y, which are equally valued or
preferred by a consumer, are to be exchanged is known as the marginal rate
of substitution (MRS) which can be computed using the following formula:

MRSxy = ∆Y
∆X

It should be emphasized that the marginal rate of substitution (MRS) is the


personal exchange rate of the consumer and not market exchange rate.

Using the combinations of bananas and biscuits as shown by our indifference


schedule, let us determine Consumer A’s marginal rate of substitution for the
two fruits.

Principles of Economics, Taxation and Agrarian Reform 13


Theory of Consumer Behavior

Marginal Rate of Substitution

Combination Biscuits Bananas MRS of


X for Y
1 1 12
2 2 8 4:1
3 3 5 3:1
4 4 3 2:1
5 5 2 1:1

In the table given above, all the five combinations of bananas and biscuits
give the same satisfaction to Consumer A. Opting for Combination 1 would
mean getting 1 piece of biscuit and 12 pieces of bananas.

For the second combination, Consumer A gets one more piece of biscuit and
gives up 4 pieces of banana for it to maintain the same level of satisfaction
resulting to 4:1 MRS. Computing further up to the 5th combination showed a
diminishing marginal rate of substitution. As the table shows as Consumer A
moves from 4th to 5th combination the MRS falls to 1:1.

The concept of marginal rate of substitution (MRS) can also be illustrated


with the help of the following diagram:

1
∆Y
5
2
5 3
5 4
5
5
∆x

14 Principles of Economics, Taxation and Agrarian Reform


Theory of Consumer Behavior

As shown above, as Consumer A moves down from Combination 1 to


Combination 2, he is willing to give up 4 pieces of bananas (∆Y) to get an
additional piece of biscuits (∆X). It should be noted that the length of ∆Y
becomes smaller and smaller, as Consumer A slides down from Combination
2 to 5, while the length of ∆X remains constant. This shows that as Consumer
A increases his demand or consumption for biscuits, his utilization for
bananas decreases.

The indifference curve IC slopes downward from left to the right, indicating a
negative and diminishing rate of substitution of one commodity for the other.

The Marginal Rate of Substitution (MRS) is more realistic and scientific,


since it takes into account the combination of other related products a
consumer is interested to purchase. MRS is a relative concept and is not
absolute.

(4) Indifference Curves cannot intersect each other

It is because at the point of tangency, the higher curve will give as much as
the two commodities as is given by the lower indifference curve .

Principles of Economics, Taxation and Agrarian Reform 15


Theory of Consumer Behavior

(5) Indifference Curves do not touch the horizontal or vertical axis

One of the basic assumptions of indifference curves is that the consumer


purchases combinations of different commodities. Hence, the indifference
curve will not touch any of the axes, where quantity for both commodities is
zero.

16 Principles of Economics, Taxation and Agrarian Reform


Theory of Consumer Behavior

IV. The Budget Line and Consumer’s Equilibrium


A budget line or price line represents the various combinations of two goods which can
be purchased with a given money income and assumed prices of goods.

The indifference map shows people’s preferences for the combination of two goods. The
actual choices they will make, however, depend on their income. The budget line is
drawn as a continuous line. It identifies the options from which the consumer can choose
the combination of goods.

Consumer A has a daily budget of P60.00 to buy bananas and biscuits. Biscuit costs
P12.00/piece, while bananas are being sold at an average of P5.00/piece.

Budget Schedule
Combination Biscuits Bananas
1 0 12
2 1.7 8
3 2.5 6
4 2.9 5
5 3.8 3
6 5 0

If Consumer A opted to buy 12 pieces of bananas at P5.00/piece, he will be spending his


total budget for bananas, and none for biscuits (Combination 1).

Combination 6, on the other hand shows that Consumer A can also spend his P60.00 to
purchase 5 pieces of biscuits priced at P12.00/piece.

In between the two extremes are the possible combinations of bananas and biscuits
wherein Consumer A can spend the total budget of P60.00.

Consumer's Equilibrium through Indifference Curve Analysis

Consumer equilibrium is the point at which a consumer reaches optimum utility or


satisfaction, from the goods and services purchased given the constraints of
income and prices. Equilibrium is reached when the consumer purchases the assortment
of goods which meets his satisfaction requirements best given his financial constraints.

The consumer’s equilibrium can be determined by combining the budget line and the
indifference map. A consumer is said to be in equilibrium at a point where the price line
is touching or tangent to the highest attainable indifference curve.

Principles of Economics, Taxation and Agrarian Reform 17


Theory of Consumer Behavior

Budget Line

M
B
PT

The above diagram shows three indifference curves IC1, IC2 and IC3. The budget line is
tangent to the indifference curve IC2 at point PT. Consumer A gets the maximum satisfaction or
is in equilibrium at point PT by purchasing 3 pieces of biscuits and 5 pieces of bananas with the
given budget.

Consumer A cannot be in equilibrium at any other point on indifference curves. Point B lies
below IC1 which is within the budget line, but IC1 yields less satisfaction. Considering Point M
at IC3, Consumer A gets the higher satisfaction but it is outside the budget line, hence he cannot
afford it. The consumer’s equilibrium position is only at point PT where the budget line is
tangent to the highest attainable indifference curve IC2.

18 Principles of Economics, Taxation and Agrarian Reform


Theory of Consumer Behavior

References:
Mankiw, G.N., (2012). Essentials of Economics 6th Edition. Harvard University: South-Western,
Cengage Learning

Mastrianna F.V., (2013).Basic Economics 16th Edition. South-Western Cengage Learning

McConnel, C., et.al (2012). Economics: Principles, Problems, and Policies (Global Edition).
McGraw Hill Co., Inc.

Paraiso, O.C., et.al (2011). Introduction to Microeconomics, Mutya Publishing House, Inc.

Stock, W.A., (2013) Introduction to Economics: Social Issues

http://www.amosweb.com
http://beta.tutor2u.net/economics
http://www.buzzle.com/
http://economicsconcepts.com/
http://economicswebinstitute.org
https://ph.images.search.yahoo.com
http://www.merriam-webster.com
http://www.investorwords.com
www.investopedia.com/
http://en.wikipedia.org/

Principles of Economics, Taxation and Agrarian Reform 19


Theory of Production
Learning Objectives
 Explain the production function.
 Explain the principle of diminishing
marginal returns.
 Discuss the stages of production in
relation to the product curves.
 Differentiate production isoquants and
isocosts .
What is Production?
Production
Factors of Production
Fixed and Variable Inputs
Fixed resource is an input for the production of
goods and services that does not change in the
short run like factory, building, equipment, or other
capital used in production.

Variable Resource an input whose quantity can


be changed in the time period under consideration
like labor and raw materials.
Short Run and Long Run in Production

Short –run is a period of time during which at


least one input is fixed while the others are
variable. It is short enough that not all factors of
production can be adjusted.

Long–run is a period of time long enough that


all factors of production can be adjusted.
Production
function: Q = f (x)
The established Q = Output
physical f= is an function of
relationship among X = Inputs
inputs, process,
and outputs in a MP= Marginal Product
production MP= ∆TP
situation and can ∆X
be expressed in AP= Average Product
mathematical AP= TP
form: X
Schedule of Total Product
INPUTS TP MP AP
0 0 ***** ****
1 5 5 5
2 12 7 6
3 20 8 6.7
4 27 7 6.8
5 33 6 6.6
6 38 5 6.3
7 42 4 7
8 45 3 5.7
9 42 -3 4.8
10 38 -4 3.8
PRODUCT CURVES
50
40
30
20 TP
10
0
0 1 2 3 4 5 6 7 8 9 10
Diminishing Marginal Product
INPUTS TP
0 0 50
1 5 40
2 12
3 20 30
4 27 20 TP
5 33
10
6 38
7 42 0
8 45 0 1 2 3 4 5 6 7 8 9 10
9 42
10 38

The principle that as successive increments of a variable


resource are added to a fixed resource, the marginal
product of the variable resource will eventually decrease.
STAGES OF PRODUCTION
50
STAGE 2 STAGE 3
40
STAGE 1
30
20 TP
10
0
0 1 2 3 4 5 6 7 8 9 10
Stages of Diminishing Productivity
STAGE 1 STAGE 2 STAGE 3
Increasing Returns Decreasing Increase in Negative Returns
Returns

TP increases Increases and reaches Decreases


maximum

AP Increases and Reaches Begins to decline Decreases


maximum

MP MP > AP Decreases and Negative


becomes zero
Production Isoquant
• Isoquant is also called as
equal product curve or
production indifference
curve or constant product
curve.
• Isoquant indicates
various combinations of
two factors of production
which give the same level
of output per unit of
time.
Characteristics of Isoquant
Isoquants do not intersect
A higher IQ implies a higher level of output
IQs are convex to the origin:
Isoquants possess continuous substitutability of
K and L over a stretch. Beyond this stretch, K and
L are not substitutable for each other.
Isocost
Isocost curve is the locus traced out by various
combinations of L and K, each of which costs the
producer the same amount of money .
Optimal Combination of Inputs
The point of tangency between the isocost and an
isoquant is an important but not a necessary
condition for producer’s equilibrium.
Reference
Mankiw, G.N., (2012). Essentials of Economics 6th Edition. Harvard
University: South-Western, Cengage Learning
Mastrianna F.V.(2013).Basic Economics 16th Edition. South-Western
Cengage Learning
McConnel, C. et.al (2012). Economics: Principles, Problems, and Policies
(Global Edition). McGraw Hill Co., Inc.
Paraiso O.C. et.al (2011). Introduction to Microeconomics, Mutya
Publishing House, Inc.
Stock W.A., (2013) Introduction to Economics: Social Issues and
Economic Thinking

Internet Sites:
http://glossary.econguru.com/
ph.images.search.yahoo.com
http://wikieducator.org/
Theory of Production

5
Theory of Production
“Production is thus at the same time consumption, and consumption is at the same time
production. Each is simultaneously its opposite. But an intermediary movement takes place
between the two at the same time. Production leads to consumption, for which it provides the
material; consumption without production would have no object. But consumption also leads to
production by providing for its products the subject for whom they are products. Without
production, there is no consumption, but without consumption there is no production either, since
in that case, production would be useless”. (Karl Marx: Critique of Political Economy)

Objectives:

After studying this chapter, the students should be able to:

1. Explain the production function


2. Explain the principle of diminishing marginal returns
3. Discuss the stages of production in relation to the product curves
4. Differentiate production isoquants and isocosts

I. What is Production?
Production is a process of combining various material inputs and immaterial inputs
(plans, know-how) in order to make something for consumption (the output). It is the act
of creating output, a good or service which has value and contributes to the utility of
individuals.

Principles of Economics, Taxation and Agrarian Reform 1


Theory of Production

Business Dictionary defines production as something that refers to the processes used and
methods to transform tangible inputs (raw materials, semi-finished goods, subassemblies)
and intangible inputs (ideas, information, knowledge) into good or
services. Resources are used in this process to create an output that is suitable for use or
has exchange value.

Refer to Chapter 1: Introduction to Economics for the detailed discussion about the
economic resources or factors of production namely land, labor, capital, and
entrepreneurship.

II. Theory of production

2 Principles of Economics, Taxation and Agrarian Reform


Theory of Production

The theory of production explains the principles by which a business firm decides how
much of each commodity that it sells will produce as well as how much of each kind of
its inputs or factors of production it will use. This includes the relationship between the
prices of goods and services and the cost of production inputs.

III. Production Function:

Considering the product quality and the prices of the corresponding production inputs,
every producer’s objective is to find the most efficient way and the cheapest combination
of factors of production that can produce the goods and services. A resource input
combination is said to be efficient if lesser quantity of any one or more inputs results to
increased production.

The relationship between the quantities of production inputs and outputs can be
expressed in an equation called the production function. The established physical
relationship among inputs, process, and outputs in a production situation can be
expressed in mathematical form:

Q = f (x)

Where: Q = Output
f = is a function of
X = Inputs

Fixed and Variable Inputs

Fixed resource is an input for the production of goods and services that does not change
in the short run like factory, building, equipment, or other capital used in production. It is
not affected by the volume of production. When business is doing well, the company
cannot immediately construct a new factory, hence, it remains fixed. When one is renting
office space and has a contract to lease for a year, the company has to pay the fixed
monthly rental, even if there is a boom or lull in production.

Variable resource is an input whose quantity can be changed in the time period under
consideration like labor and raw materials. The company can decide to hire additional
workers to be able to meet the increasing demand for its product or service and to lay-off
some when called for. The raw materials can likewise be adjusted depending on the
volume of production, hence, classified as a variable resource.

IV. Short Run and Long Run in Production

Principles of Economics, Taxation and Agrarian Reform 3


Theory of Production

Short–run is a period of time during which at least one input is fixed while the others are
variable. It is short enough that not all factors of production can be adjusted. The
company has not yet utilized the full capacity of its plant, hence, a fixed input to meet the
increasing demand for its product with additional labor and raw materials as variable
input.

Long–run is a period of time long enough that all factors of production can be adjusted.
With the business continuous growth and more investors coming in, the company can
venture into construction of additional plants and warehouse, upgrading its machineries
and equipments, increase its manpower, and contract additional suppliers. All production
inputs are being adjusted to meet the increasing business operations.

V. Law of Diminishing Returns

The law of diminishing return in productivity states that if some inputs are held
constant while others vary, the marginal productivity will decline at some point as a
result of adding more units of the variable inputs.

Table 4.1: Schedule of Total Product

INPUTS (X) TP MP AP
0 0 ***** ****
1 5 5 5
2 12 7 6
3 20 8 6.7
4 27 7 6.8
5 33 6 6.6
6 38 5 6.3
7 42 4 7
8 45 3 5.7
9 42 -3 4.8
10 38 -4 3.8

Production in the short run is influenced by the Law of Diminishing Returns.

1. Total Product (TP) is the total amount of production employing the necessary
factors of production over a certain period of time.

2. Marginal Product (MP) is the change in total product per unit change in the
quantity of the variable input (X) holding the level of usage of all other inputs
constant

4 Principles of Economics, Taxation and Agrarian Reform


Theory of Production

MP = ∆TP
∆X

3. Average Product (AP) is the total product per unit of variable input
AP = TP
X
VI. The Product Curves
Graphical representations of Table 4.1: Schedule of Total Product
Total Production
50
40
30
20 TP
10
0
0 1 2 3 4 5 6 7 8 9 10
Input (X)

MP/AP

VII. STAGES OF PRODUCTION Input (X)

VI. The Stages of Production and Diminishing Marginal Returns


TP
50
40
Principles of Economics, Taxation and Agrarian Reform 5
30
20 TP
Theory of Production

Stage 1
Stage 2
Stage 3

Input (X)

MP/AP

Input (X)

Stage 1 of the production process is characterized by increasing TP; AP increases and


reaches maximum; MP increases and reaches maximum and decreases; MP is greater
than AP, except when AP is maximum; boundary of Stage 1 and 2 is the intersection of
AP and MP; AP intersects MP at its maximum point.

Stage 2 of the production process corresponds to decreasing increase in return. AP begins


to decline; TP increases and reaches maximum; MP decreases and becomes zero (0).
Based on the graphs, Stage 2 is from range of X from 4 to 8. The end point of Stage 2 is
the point of maximum output on the TP curve, when MP is equal to zero. This serves as
the boundary between Stages 2 and 3. Both the MP and the AP are declining at this level.

Stage 3 is characterized by negative returns. The TP and the AP are both decreasing
while the MP is negative. Stage 3 occurs when the input (X) exceeds 8.

STAGE 1 STAGE 2 STAGE 3

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Theory of Production

Increasing Decreasing Negative


Returns Increase in Returns
Returns
TP increases Increases and Decreases
reaches
maximum
AP Increases and Begins to Decreases
Reaches decline
maximum
MP MP > AP Decreases and Negative
becomes zero
Stages of Diminishing Productivity

VII. Production Isoquants and Isocost

Isoquant indicates various combinations of two factors of production which give the
same level of output per unit of time.

Isoquant is also called as equal product curve or production indifference curve or


constant product curve.

Principles of Economics, Taxation and Agrarian Reform 7


Theory of Production

Characteristics of Isoquant

1. Isoquants do not intersect

2. A higher IQ implies a higher level of output

8 Principles of Economics, Taxation and Agrarian Reform


Theory of Production

3. IQs are convex to the origin:

Isoquants possess continuous substitutability of K and L over a stretch. Beyond this


stretch, K and L are not substitutable for each other.

An isoquant map is composed of series of isoquants as shown below:

Principles of Economics, Taxation and Agrarian Reform 9


Theory of Production

Isocosts

Isocost curve is a producer's budget line. It is the locus traced out by various
combinations of L and K, each of which costs the producer the same amount of money.

An isocost line is also called outlay line or price line or factor cost line. An isocost line
shows all the combinations of labor and capital that are available for a given total cost to-
the producer. The greater the total cost, the further from origin is the isocost line.

10 Principles of Economics, Taxation and Agrarian Reform


Theory of Production

Optimal Combination of Inputs

The isocost line is combined with the isoquant map to determine the optimal production point at
any given level of output. The point of tangency between any isoquant and an isocost line gives
the lowest-cost combination of inputs that can produce the level of output associated with that
isoquant. This analysis is based on the following assumptions:

1. There are two factors: labor and capital.


2. All units of labor and capital are homogeneous.
3. The prices of units of labor (L) and that of capital (K) are given and constant.
4. The cost outlay is given.
5. The firm produces a single product.
6. The price of the product is given and constant.
7. The firm aims at profit maximization
8. There is perfect competition in the factor market

Referring to the graph below, the optimal combination of inputs given a certain budget would be
at the point of tangency of the isocost line (red line) and isoquant IQ3 with K2 units of capital
and L2 units of labor.

Principles of Economics, Taxation and Agrarian Reform 11


Theory of Production

References:

Mankiw, G.N., (2012). Essentials of Economics 6th Edition. Harvard University: South-
Western, Cengage Learning

Mastrianna, F.V., (2013).Basic Economics 16th Edition. South-Western Cengage


Learning

McConnel, C., et.al (2012). Economics: Principles, Problems, and Policies (Global
Edition). McGraw Hill Co., Inc.

Paraiso, O.C., et.al (2011). Introduction to Microeconomics, Mutya Publishing House,


Inc.

Stock, W.A., (2013) Introduction to Economics: Social Issues and Economic Thinking

http://www.businessdictionary.com
http://glossary.econguru.com/
ph.images.search.yahoo.com
http://wikieducator.org

12 Principles of Economics, Taxation and Agrarian Reform


Theory of Production
Learning Objectives
 Explain the production function.
 Explain the principle of diminishing
marginal returns.
 Discuss the stages of production in
relation to the product curves.
 Differentiate production isoquants and
isocosts .
What is Production?
Production
Factors of Production
Fixed and Variable Inputs
Fixed resource is an input for the production of
goods and services that does not change in the
short run like factory, building, equipment, or other
capital used in production.

Variable Resource an input whose quantity can


be changed in the time period under consideration
like labor and raw materials.
Short Run and Long Run in Production

Short –run is a period of time during which at


least one input is fixed while the others are
variable. It is short enough that not all factors of
production can be adjusted.

Long–run is a period of time long enough that


all factors of production can be adjusted.
Production
function: Q = f (x)
The established Q = Output
physical f= is an function of
relationship among X = Inputs
inputs, process,
and outputs in a MP= Marginal Product
production MP= ∆TP
situation and can ∆X
be expressed in AP= Average Product
mathematical AP= TP
form: X
Schedule of Total Product
INPUTS TP MP AP
0 0 ***** ****
1 5 5 5
2 12 7 6
3 20 8 6.7
4 27 7 6.8
5 33 6 6.6
6 38 5 6.3
7 42 4 7
8 45 3 5.7
9 42 -3 4.8
10 38 -4 3.8
PRODUCT CURVES
50
40
30
20 TP
10
0
0 1 2 3 4 5 6 7 8 9 10
Diminishing Marginal Product
INPUTS TP
0 0 50
1 5 40
2 12
3 20 30
4 27 20 TP
5 33
10
6 38
7 42 0
8 45 0 1 2 3 4 5 6 7 8 9 10
9 42
10 38

The principle that as successive increments of a variable


resource are added to a fixed resource, the marginal
product of the variable resource will eventually decrease.
STAGES OF PRODUCTION
50
STAGE 2 STAGE 3
40
STAGE 1
30
20 TP
10
0
0 1 2 3 4 5 6 7 8 9 10
Stages of Diminishing Productivity
STAGE 1 STAGE 2 STAGE 3
Increasing Returns Decreasing Increase in Negative Returns
Returns

TP increases Increases and reaches Decreases


maximum

AP Increases and Reaches Begins to decline Decreases


maximum

MP MP > AP Decreases and Negative


becomes zero
Production Isoquant
• Isoquant is also called as
equal product curve or
production indifference
curve or constant product
curve.
• Isoquant indicates
various combinations of
two factors of production
which give the same level
of output per unit of
time.
Characteristics of Isoquant
Isoquants do not intersect
A higher IQ implies a higher level of output
IQs are convex to the origin:
Isoquants possess continuous substitutability of
K and L over a stretch. Beyond this stretch, K and
L are not substitutable for each other.
Isocost
Isocost curve is the locus traced out by various
combinations of L and K, each of which costs the
producer the same amount of money .
Optimal Combination of Inputs
The point of tangency between the isocost and an
isoquant is an important but not a necessary
condition for producer’s equilibrium.
Reference
Mankiw, G.N., (2012). Essentials of Economics 6th Edition. Harvard
University: South-Western, Cengage Learning
Mastrianna F.V.(2013).Basic Economics 16th Edition. South-Western
Cengage Learning
McConnel, C. et.al (2012). Economics: Principles, Problems, and Policies
(Global Edition). McGraw Hill Co., Inc.
Paraiso O.C. et.al (2011). Introduction to Microeconomics, Mutya
Publishing House, Inc.
Stock W.A., (2013) Introduction to Economics: Social Issues and
Economic Thinking

Internet Sites:
http://glossary.econguru.com/
ph.images.search.yahoo.com
http://wikieducator.org/
THEORY OF COST AND PROFIT
Learning Objectives

• Explain the relationship among the different economic costs.

• Differentiate between economic profit and accounting profit.


Types of Economic Costs
• Explicit Cost – also called the
expenditure cost. Payments to the
owners of the factors of production like
wage, interests, raw materials
• Implicit Cost – a firm’s opportunity cost
of using its own factors of production
without a corresponding cash payment
like rent for land.
Types of Economic Costs
Fixed Cost (FC) - does not change with an
increase or decrease in the amount of goods
or services produced.
Variable Cost (VC)- expense that varies
with production output. they rise as
production increases and fall as production
decreases.
Total Cost (TC) = the market value of all the
inputs used by the firm in production (FC + VC)
Types of Economic Costs

• Opportunity cost - The cost of an alternative


that must be forgone in order to pursue a
certain action.
Types of Economic Costs
• Average Cost (AC) – also called the unit
cost
AC = TC
Q
• Marginal Cost (MC) – extra cost for
producing one additional unit of output
MC = ∆TC
∆Q
TOTAL COST DATA
OUTPUT TFC TVC TC
0 40 0 40
2 40 70 110
3 40 130 170
4 40 180 220
5 40 240 280
6 40 310 350
7 40 380 420
8 40 460 500
9 40 550 590
10 40 650 690
Total Cost Curves
COST
AVERAGE COST DATA
OUTPUT AFC AVC ATC MC
0 40 0 40
2 20 35 55 35
3 13 43 57 60
4 10 45 55 50
5 8 48 56 60
6 7 50 57 60
7 6 53 59 70
8 5 56 61 80
9 4 60 64 90
10 4 64 68 100
Average Cost Curves
COST
REVENUE AND PROFIT
Total Revenue and Marginal Revenue
• Total Revenue (TR) - income received
from the sale of goods and services.
TR = Price X output
Marginal Revenue (MR) = the change in
the total revenue resulting from the sale
of one unit of output.
MR = ∆TR
∆Q
Profit and Loss Data
OUTPUT TC MC TR MR Profit/(Loss)
1 40 60 20
2 110 70 120 60 10
3 170 60 180 60 10
4 220 50 240 60 20
5 280 60 300 60 20
6 340 60 360 60 20
7 410 70 420 60 10
8 490 80 480 60 -10
9 580 90 540 60 -40
10 680 100 600 60 -80
Total Revenue vs Total Cost
COST
Break-even Point
• The level of output at which total
revenue equals total cost and can be
determined using 3 approaches:
1.Based on the total cost and total
revenue schedule. Analyze the
entries. The break-even point is
when Total revenue = Total cost.
Break-even Point

2. Graphing - the point of intersection


between the total cost and total revenue
curves
Total Revenue vs Total Cost
COST
Break-even Point
3. Mathematical computation using the following
basic equation:
TR = TC
P X Q = TFC + TVC
Break-even volume:
Q be = TFC+TVC
P
Break-even price :
P be = TFC+TVC
Q
Exercise 6.1

OUTPUT TFC TVC TC TR P/L


0 0 35
4 50
6 65
8 85
10 100
12 135
14 175
16 230
18 300
20 350
a) Complete the cost and revenue schedule. Selling price is at P17.00/unit.

b) Determine the breakeven point through graphical method. Identify the


profit and loss areas. Label your graph properly.
Exercise 6.1

OUTPUT TFC TVC TC TR P/L


0 35 0 35 0 -35
4 35 50 85 68 -17
6 35 65 100 102 2
8 35 85 120 136 16
10 35 100 135 170 35
12 35 135 170 204 34
14 35 175 210 238 28
16 35 230 265 272 7
18 35 300 335 306 -29
20 35 350 385 340 -45
Exercise 6.1

C
O
S
T

A
N
D

R
E
V
E
N
U
E

OUTPUT
Exercise 6.1

C
O
S
T

A
N
D

R
E
V
E
N
U
E
OUTPUT
References
Mankiw, G.N., (2012). Essentials of Economics 6th Edition. Harvard
University: South-Western, Cengage Learning
Mastrianna F.V.(2013).Basic Economics 16th Edition. South-Western
Cengage Learning
McConnel, C. et.al (2012). Economics: Principles, Problems, and
Policies (Global Edition). McGraw Hill Co., Inc.
Paraiso O.C. et.al (2011). Introduction to Microeconomics, Mutya
Publishing House, Inc.
Stock W.A., (2013) Introduction to Economics: Social Issues and
Economic Thinking

Interrn Sites:

https://ph.images.search.yahoo.com
http://www.intelligenteconomist.com/
http://www.investopedia.com/
Theory of Cost and Profit

6
Theory of Cost and Profit
The relationships and the interactions of consumers and producers can be easily understood
using the economic model in Chapter 1 showing the Circular flow of Income. Chapter 5 on the
Theory of Consumer Behavior discusses the demand side of the market flow. We had initially
presented the Theory of Production in Chapter 5 focusing on the physical production-inputs and
outputs. In this chapter, we will continue to study the behavior of the firm (producers and
sellers), the supply side of the product market in terms of the relationships between costs and
output.

Objectives:

After studying this chapter, the students should be able to:

• Account for the factors that comprise a firm’s cost


• Explain the relationship among the different economic costs
• Differentiate between economic profit and accounting profit
• Explain how firms decide what and how to produce.

I. The Production and Costs


Production cost is a determinant of supply and exhibits an inverse relationship.
Thus, the objective of producers is to generate products and services at the lowest cost
possible without sacrificing quality. High production cost means higher prices for their
products which could limit the consumer demand while less cost would mean increase
demand for the product resulting to higher sales and chance for higher profit.

To produce a good or a service, a firm needs economic resources or factors of


production referred to as inputs and process them into outputs. The firm has to pay for
these inputs and in the process, generate costs. As discussed in Chapter 1, the inputs or
factors of production are the following with their corresponding factor payments:

Factor of Production Factor Payments


or Input
Land Rent
Labor Salary or Wage
Capital Interest
Entrepreneur Profit

Cost of production is the sum of the costs of all inputs used in production.

Principles of Economics, Taxation and Agrarian Reform 1


Theory of Cost and Profit

Types of Economic Cost


1. Explicit Cost

Payments to the owners of the factors of production like wage, interests, and raw
materials. It is also called the expenditure cost and requires money outlay from
the firm.

2. Implicit Cost

This is the firm’s opportunity cost of using its own factors of production without a
corresponding cash payment like rent for land. In economics, implicit costs are
taken into account in determining the performance of the firm (profit or loss).

3. Opportunity Cost

This refers to the cost of foregone opportunity or alternative benefit. It is the value
of the next-highest-valued alternative use of that resource

4. Fixed Cost (FC)

Fixed cost is the type of cost which remains constant regardless of the volume of
production. It does not change with an increase or decrease in the amount of
goods or services produced. Even at zero production the firm still incurs this cost.
Rent for stalls and offices has to be paid whether you utilize them or not.

5. Average Fixed Cost (AFC)

Average Fixed Cost (AFC) is total fixed cost divided by the quantity of the
output:

AFC = TFC
Q

6. Variable Cost (VC)

Costs that vary or change depending on the volume of production are called
variable costs. They rise as production increases and fall as production decreases
like raw materials, wages and salaries.

7. Average Variable Cost (AVC)

Total variable cost divided by the quantity of the output or AVC = TFC
Q

2 Principles of Economics, Taxation and Agrarian Reform


Theory of Cost and Profit

8. Total Cost (TC)

Total cost is the market value of all the inputs used by the firm in production. It is
the sum of all the fixed and variable costs incurred by the firm in producing its
products.
TC = FC + VC

9. Average Cost (AC)

Average cost is also called the unit cost and is equivalent to the total cost divided
evenly by the quantity of the output.
AC = TC
Q

Average cost can also be expressed as the sum of Average Fixed Cost (AFC) and
Average Variable Cost (AVC), since total cost is just the sum of fixed and
variable cost.
AC = AFC + AVC

10. Marginal Cost (AC)

This cost refers to the increase in total cost from producing one extra unit of
output. It is also known as the slope of the total cost curve. Marginal cost is
obtained by dividing change in total cost by change in quantity of the output.

MC = ∆TC
∆Q

Short Run Cost Curves

Principles of Economics, Taxation and Agrarian Reform 3


Theory of Cost and Profit
A. Total Cost Curves
Graphs are useful to better understand the relationships between production and costs.
The Total Product Curves below are based on Table 6.1: Total Cost and Output Schedule
of LAM Company, on the short run. It can be noted that at least one input is fixed.

Table 6.1: Total Costs and Output Schedule


OUTPUT TFC TVC TC
0 40 0 40
2 40 70 110
3 40 130 170
4 40 180 220
5 40 240 280
6 40 310 350
7 40 380 420
8 40 460 500
9 40 550 590
10 40 650 690

Total Cost Curves


COST
800

700

600

500
TFC
400
TVC
300 TC
200

100
OUTPUT
0
0 2 3 4 5 6 7 8 9 10

The cost curves show the relationship between the quantity of production and the costs
involved in production. The total cost curve gets steeper as the production increases
because of the diminishing marginal product. The graph above clearly shows the
behavior of the fixed and variable costs, the components of the total cost. Fixed cost is
constant at all level of production, while the variable cost increases with more
production.

4 Principles of Economics, Taxation and Agrarian Reform


Theory of Cost and Profit

B. Average and Marginal Costs Curves


Table 6.2 on the average cost schedule was based on Table 6.1: Total Cost and Output
Schedule.

Table 6.2: AVERAGE COSTS SCHEDULE


OUTPUT AFC AVC ATC MC
0 0 0 0
2 20 35 55 35
3 13 44 57 60
4 10 45 55 50
5 8 48 56 60
6 7 51 58 70
7 6 54 60 70
8 5 57 62 80
9 5 61 66 90
10 4 65 69 100

Looking more closely, both at the schedule and the graph, reveal that the marginal cost
generally rises as the output increases. When the MC is lower than the average total cost
(ATC), the average total cost is falling. On the other hand, when the MC is higher than
the ATC, the ATC is rising. It crosses the average cost curve at its minimum.

Average Cost Curves


COST
120

100

80
AFC
60 AVC
AC
40
MC
20

0 OUTPUT
0 2 3 4 5 6 7 8 9 10

Principles of Economics, Taxation and Agrarian Reform 5


Theory of Cost and Profit
III. REVENUE AND PROFIT
A. Total Revenue and Marginal Revenue
Total revenue (TR) refers to the total receipts from sales of a given quantity of goods or
services. It is the total income of a firm and is calculated by multiplying the quantity of
goods (Q) sold by the price (P) of the goods.

TR = P x Q

Other concepts related to total revenue are the average revenue (AR) and marginal
revenue (MR).

Average revenue refers to the revenue per unit of output sold and is computed by
dividing the total revenue by the number of units sold.

Marginal revenue (MR) is the additional income generated from the sale of an
additional unit of output. It is the change in total revenue from the sale of one more unit
of a good. MR = ∆TR
∆Q

Table 6.3: Profit and Loss Schedule


OUTPUT TC MC TR MR Profit/(Loss)
0 40 0 20
2 110 35 120 60 10
3 170 60 180 60 10
4 220 50 240 60 20
5 280 60 300 60 20
6 350 70 360 60 10
7 420 70 420 60 0
8 500 80 480 60 -20
9 590 90 540 60 -40
10 690 100 600 60 -80

LAM Company sells its product at P60.00/unit and Table 6.3 shows the company’s
performance at various levels of production. The level that would give the company the
highest profit based on output and pricing is the profit maximization point.

Profit maximization can be determined through the Marginal Cost – Marginal Revenue
Method and the Total Cost-Total Revenue Method. The Marginal Cost – Marginal
Revenue Method is based on the fact that total profit reaches its maximum point where
marginal revenue equals marginal cost. On the other hand, the total revenue–total cost
focuses on maximizing the difference between revenue and costs which is equal to the
company’s profit.

6 Principles of Economics, Taxation and Agrarian Reform


Theory of Cost and Profit

TOTAL REVENUE AND TOTAL COST CURVES

C IV. ..
O
V. ..
S
VI.
T

B. Break-even Point
The break-even point (BEP) is the point at which total cost and total revenue are equal:
there is no net loss or gain. A profit or a loss has not been made, but all costs that need to
be paid were fully settled. The level of output at which total revenue equals total cost and
can be determined using 3 approaches:

1. Based on the total cost and total revenue schedule. Analyze the entries. The break-even
point is when total revenue = total cost. In Table 6.3, LAM Company’s break-even
point is at Output 7, where the total cost and total revenue were both at P 420.00.

2. Graphing - the point of intersection between the total cost and total revenue curves

Principles of Economics, Taxation and Agrarian Reform 7


Theory of Cost and Profit
3. Mathematical computation using the following basic equation:

where:

 TFC is Total Fixed Costs,


 P is Unit Sale Price, and
 V is Unit Variable Cost.

8 Principles of Economics, Taxation and Agrarian Reform


Theory of Cost and Profit

References:

Mankiw, G.N., (2012). Essentials of Economics 6th Edition. Harvard University: South-Western,
Cengage Learning

Mastrianna, F.V., (2013). Basic Economics 16th Edition. South-Western Cengage Learning

McConnel, C., et.al (2012). Economics: Principles, Problems, and Policies (Global Edition).
McGraw Hill Co., Inc.

Paraiso, O.C., et.al (2011). Introduction to Microeconomics, Mutya Publishing House, Inc.

Stock, W.A., (2013) Introduction to Economics: Social Issues and Economic Thinking

http://ph.images.search.yahoo.com
http://www.intelligenteconomist.com
http://www.investopedia.com

Principles of Economics, Taxation and Agrarian Reform 9


MARKET STRUCTURES
Learning Objectives
• Differentiate perfect competition from other market
structures

• Draw and explain the graph showing ATC, AVC, MC, and
MR and determine the profit maximization point

• Understand the pricing structure and why the profit


maximization position of a firm in perfect competition
occurs at that point where MR = MC
What is a Market
• A market is a set of conditions in which buyers
and sellers meet each other for the purpose of
exchange of goods and services for money.

• An actual or nominal place where forces of


demand and supply operate, and where
buyers and sellers interact (directly or
through intermediaries) to trade goods and
services for money or barter.
What is Market Structure
• The interconnected characteristics of a market such as the number
and relative strength of buyers and sellers , level and forms of
competition, extent of product differentiation, ease of entry into and
exit from the market.

• The selling environment in which a firm produces and sells its product
defined by the number of firms in the market; the ease of entry and
exit of firms, and the degree of product differentiation
Market Categories
and
Structures
Perfect Competition
Characteristics
 Numerous sellers all selling identical products: no differences in
quality, no brands, no advertising

 All buyers are well-informed about markets and prices

 There is free entry into and exit from the market

 No individual seller or buyer can influence the market price which is


determined by the interplay of the market supply and demand. All
are price takers.
Products under Perfect Competition
Price and Profit in the Short Run
• The individual firm faces a perfectly elastic demand curve, and that the firm’s
supply can all be sold at the market determined price as shown by the graph
below:
Price and Profit in the Short Run
• Marginal revenue (MR) is the increase in total revenue resulting from a
one-unit increase in output. Since the price is constant in the perfect
competition, the increase in total revenue from producing 1 extra unit will
equal to the price or P = MR.
HYPOTHETICAL CASE:

AVERAGE COST AND REVENUE DATA


OUTPUT AC MC MR AVC Profit/(Loss)

2 23 13 17 15 -6
4 21 11 17 13 -4
6 17 8 17 11 0
8 15 10 17 11 2
10 14 12 17 10 3
12 14 17 17 11 3
14 15 20 17 13 2
16 17 28 17 14 0
18 19 35 17 17 -2
20 19 36 17 18 -2

At the market price of P17.00/unit, MC = MR at 12 units of production, the


equilibrium output.
GRAPHICAL ANALYSIS :

Profit Maximization for a Competitive Firm

C The firm maximizes profit


O by producing the quantity
S where MC=MR
T

&

R
E
V
E
N
U
E
OUTPUT

If MC < MR – additional output will increase profit


If MC > MR - decrease in output will increase profit
MC = MR - the short run profit is at the maximum
References
Mankiw, G.N., (2012). Essentials of Economics 6th Edition. Harvard University:
South-Western, Cengage Learning
Mastrianna F.V.(2013).Basic Economics 16th Edition. South-Western Cengage
Learning
McConnel, C. et.al (2012). Economics: Principles, Problems, and Policies (Global
Edition). McGraw Hill Co., Inc.
Paraiso O.C. et.al (2011). Introduction to Microeconomics, Mutya Publishing House,
Inc.
Stock W.A., (2013) Introduction to Economics: Social Issues and Economic Thinking

Internet Sites:
http://www.businessdictionary.com/
http://economicsconcepts.com/
www.economicsonlinetutor.com
https://ph.images.search.yahoo.com
http://www.intelligenteconomist.com/
http://www.investopedia.com/
Market Categories and Structures

7
Market Categories and Structures
A market is a set of conditions in which buyers and sellers meet each other for the purpose of
exchange of goods and services for money. Market is an actual or nominal place where forces of
demand and supply operate, and where buyers and sellers interact directly or through intermediaries,
to trade goods and services for money or barter.

A market structure refers to the composition and characteristic of the market that influence the
operation of the firms. Some factors that determine market structures are: the number of sellers and
buyers; their relative negotiation strength, in terms of ability to set prices; the degree of
concentration among them; the degree of differentiation and uniqueness of products; and the ease of
entry and exit from the market. The interaction and differences between these factors, together with
competition lead to the development of market structures.

Objectives:

After studying this chapter, the students should be able to:

1. Identify the determinants of the market structure


2. Differentiate the four (4) market structures in terms of their respective characteristics.
3. Understand the pricing structure, output and profit maximization determination of each
market structure.

Principles of Economics, Taxation and Agrarian Reform 1


Market Categories and Structures

I. Definition of Market Structure


Market structure refers to the nature and degree of competition in the market for goods and services.
The presence or absence of competition is a major factor in determining market structures as shown
by the following spectrum from perfect competition to pure monopoly.

II. Determinants of Market Structure

1. Number and Nature of sellers/buyers


The market structure is influenced by the number of sellers/buyers in the market. The number
can range from one (monopoly), to a few (oligopoly), to many selling differentiated products
(monopolistic competition), to a large number selling homogeneous and identical products
(perfect competition)

Principles of Economics, Taxation and Agrarian Reform 2


Market Categories and Structures

2. Nature of the product


Product differentiation is a marketing strategy whereby businesses attempt to make their
product unique to stand out from competitors. Product differentiation means that some
feature, physical attribute, or substantive difference exists between a product and all other
alternatives. Nature of the product determines the market structure. Monopolistic competition
has differentiated products which are close substitutes, but if the product is unique and has no
close substitute, a monopoly exists.

3. Ease of entry into and exit from the market


Entry into and exit from the market depend upon profitability or loss operating in a particular
market. Profits will attract new entrants to the market while losses will lead to the exit of the
weak firms from the market. In a perfect competition, there is freedom of entry and exit of
firms from the market while, for monopolistic competition, there are no restrictions in entry
or exit due to product differentiation.

4. Economies of scale
Economies of scale refer to the reduction of per-unit costs through an increase in production
volume or diminishing marginal cost. Firms that achieve large economies of scale in
production tend to weed out other firms, resulting to fewer firms left to compete with each
other. This leads to the emergence of oligopoly, a market structure characterized by few
sellers. Monopoly exists if one firm has attained economies of scale so large that it can
supply the entire market demand.

Principles of Economics, Taxation and Agrarian Reform 3


Market Categories and Structures

Principles of Economics, Taxation and Agrarian Reform 4


Market Categories and Structures

5. Control over price


How a firm, influencing the price in the market, determines the market structure is shown by
the diagram below. Sellers under a perfect competition are price takers or have low influence
in the determining market. At the other side of the spectrum, monopolists are price makers
since they have full control of the supply of their unique product.

Principles of Economics, Taxation and Agrarian Reform 5


Market Categories and Structures

Table 1 gives a summary and comparison of the characteristics and comparison of the four (4)
market structures:

Table 1: Comparison of the Four Market Structures

Principles of Economics, Taxation and Agrarian Reform 6


Market Categories and Structures

III. Classification of Market Structure

A. Perfect Competition

1. Characteristics Perfectively Competitive Market


The market operating under the perfect competition has the following characteristics:

a. Large number of buyers and sellers


There is a large number of independent buyers or sellers. Hence, no buyer/seller can
influence the market price of the product or service. Market players (buyer or seller)
comprise such a small part of the total market, that his/her activities and decisions do
not affect the market price. The price of the product is a result of the interplay of
supply and demand for said product. In short, the firm is a “price taker” and has to
adjust its output based on the prevailing market price.

b. Homogeneous or undifferentiated products


In a perfect competition, each firm is producing or selling perfectly identical products.
This means that buyers will be indifferent to the seller they will buy from while the
sellers will be indifferent to the buyers to whom they would sell products to. Actually,
it does not matter to the buyer whether they purchase from Store 1, 2, or 3 because all
of them are offering homogeneous products from contents to packaging. This
homogeneity of the products results to the single or common price for said product.
Furthermore, advertisement and other non-price competition are not necessary under
the perfectly competitive market structure.

c. Easy entry or exit


Another feature of perfectly competitive market is the freedom to enter into the market
and leave the market. Depending on the market situation, for example, if the market is
providing opportunity for profit, small sized producers and sellers have the freedom to
grab this opportunity and join the industry. They should be allowed to compete. Their
entry, however, will mean increase supply, resulting to a lower equilibrium price for
the product at constant demand. This will lower or even deplete the profit, and
correspondingly, some firms who are incurring losses may leave or exit the market.
Their exit will reduce the supply, raising the equilibrium price. Entry and exit from the
market do not need any legal, financial and technical requirements.

d. Perfect knowledge of the economy


Market players have a perfect knowledge of the different activities and related
information like prices, quality, volume, suppliers, etc. The market is so transparent
that when a seller decreases its price, others will follow suit, to the advantage of the
consumers who can avail the product at reduced price. On the other hand, sellers who
opted to increase the selling price will lose their sale.

Principles of Economics, Taxation and Agrarian Reform 7


Market Categories and Structures

e. Control over price


Considering the characteristics of the firms under a perfect competitive market
structures, i.e. size and number of firms, identical product and knowledge of the
economy, perfectly competitive sellers and buyers are “price takers”, meaning, they
cannot influence the market price by manipulating their production and purchases,
respectively.

Products under Perfect Competition

2. Price and Output Determination under Perfectively Competition


Principles of Economics, Taxation and Agrarian Reform 8
Market Categories and Structures

Price and Profit in the Short Run

 The individual firm faces a perfectly elastic demand curve,


and that the firm’s supply can all be sold at the market
determined price as shown by the graph below:

Marginal revenue (MR) is the increase in total revenue resulting from a one-unit
increase in output. Since the price is constant in the perfect competition, the increase
in total revenue from producing 1 extra unit will equal to the price or P = MR.

Hypothetical Case:

Principles of Economics, Taxation and Agrarian Reform 9


Market Categories and Structures

AVERAGE COST AND REVENUE DATA

OUTPUT AC MC MR AVC Profit/(Loss)

2 23 13 17 15 -6
4 21 11 17 13 -4
6 17 8 17 11 0
8 15 10 17 11 2
10 14 12 17 10 3
12 14 17 17 11 3
14 15 20 17 13 2
16 17 28 17 14 0
18 19 35 17 17 -2
20 19 36 17 18 -2

At the market price of P17.00/unit, MC = MR at 12 units of production, the short


run profit is at the maximum equilibrium output.

40
35
30
25 AC
20 MC
15 MR
10 AVC

5
0
2 4 6 8 10 12 14 16 18 20

Principles of Economics, Taxation and Agrarian Reform 10


Market Categories and Structures

GRAPHICAL ANALYSIS :
Profit Maximization for a Competitive Firm

C The firm maximizes profit


O by producing the quantity
S where MC=MR
T

&

R
E
V
E
N
U
E
OUTPUT

If MC < MR – additional output will increase profit


If MC > MR - decrease in output will increase profit
MC = MR - the short run profit is at the maximum

Advantages of Competition

Low prices for all: A company has to offer a better or affordable price to gain a high market
share for its product. This is not only to the advantage of the consumers, but to the producers as
well, since the high demand for their product due to affordable price, businesses are encouraged
to produce more and to contribute to economic growth of the industry.

Better quality: Competition also encourages businesses to improve the quality of goods and
services they sell – to attract more customers and to expand market share. Quality can be
measured through longer life span for the products; better after-sales or technical support or
friendlier and better service. Competition places pressure on producers to operate efficiently and
to cater to preferences of consumers.

More choice: In a competitive market, businesses will try to make their products different from
the rest. This results in greater choice – so consumers can select the product that offers the right
balance between price and quality.

Innovation: To deliver this choice and to produce better products, businesses need to be
innovative – in their product concepts, design, production techniques, services, etc. Provides
firms with strong incentive to develop and improve products and discover cost-efficient
production method.

Principles of Economics, Taxation and Agrarian Reform 11


Market Categories and Structures

B. Monopoly
Monopoly is a market form in which a single firm controls the total supply of a single
commodity which has no close substitutes. Monopoly is technically defined as a single firm
or industry where the cross price elasticity of demand between the product of the monopolist
and the product of the closest rival is near zero, meaning the product of the rival company
cannot take the place of monopolized product.

1. Sources and Types of Monopoly


a. Natural Monopoly – if the supply of a commodity is localized in a single place
b. Legal Monopoly –a firm is given the legal right to produce a unique commodity
c. Public Monopoly – also known as welfare monopoly and is created for the interest of
the public, i.e. public utility services like electricity, water supply, telephone and
railways.
d. Private Monopoly – owned and operated by the private individuals or organizations
for the purpose of maximizing profits. This is classified as simple and discriminating
monopoly. The former charges a single or uniform price for its product, while the
latter charges more than one price for the same product from different consumers.

2. Assumptions of Monopoly
a. A monopolist has the power to determine the price and the quantity to be sold in the
market, but he has no control over the demand for the product. Hence, its demand
curve slopes downward and to sell more, he must cut or lower his price. The
monopolist will fix his output to a level that will give him the maximum possible net
profits.

b. The monopolist is a price maker but his power to influence price depends upon the
availability of close substitutes and the power to restrict the new entrants to the
market. If there are close substitutes, the monopolist, an increase in the price of the
product will lead to heavy losses. As to the power to restrict new entrants, the
monopoly firm can control the market as long as there are no potential rivals. Some
measures which can be use to prevent entry of competitors for the monopolist:

i. Control over the raw materials – the geographical distribution of natural and
mineral resources are concentrated in a particular area or region. A monopoly
can exist when the firm gains control of the raw materials and there are no
competitors for the same product.

ii. Technical barriers – large firms which can access and acquire the latest
technology needed for its product, ahead of all its competitors. They can
continue to have technical economies of scale resulting to a lower per unit
cost of the product or service.

Principles of Economics, Taxation and Agrarian Reform 12


Market Categories and Structures

iii. Legal barriers - the government creates the monopoly through statutory
regulations of the government. Licenses to operate or sell certain products,
and granting patent rights are some of the legal barriers, resulting to
monopoly.

3. Characteristics of Monopoly
a. There is one producer or seller of a particular product and the firm itself is an
industry.
b. There are different types of monopoly: natural, legal, private, or public (government)
c. A monopolist has full control of the supply of the product. Hence, the elasticity of
demand for a monopolist product is zero.
d. There is no close substitute of a monopolist’s product in the market, thus, the cross
elasticity of demand for a monopoly product with some weak substitutes is very low.
e. There are restrictions or barriers on the entry of other firms in the area of monopoly
product.
f. A monopolist can influence the price of the product. He is a price maker.
g. Monopolist cannot determine both the price and quantity of a product simultaneously.
h. There may be or no non-price competitions like advertising, sales promotions and
other market strategies, because the monopolist is the only source of the product.

4. Price and Output Determination under Monopoly


Monopolist’s demand curve slopes downwards to the right. This means that he can
increase his sales only by decreasing the price of his product and maximizing his profit.
The marginal revenue curve of a monopolist is below the average revenue curve and the
MR curve falls faster than the AR curve, because he has to decrease the price of his
product to sell an additional unit.

The price elasticity of demand acts as a constraint on the pricing-power of the monopolist.
Assuming that the monopolist aims to maximize profits (where MR=MC), we establish a
short run price and output equilibrium as shown in the diagram below:

Principles of Economics, Taxation and Agrarian Reform 13


Market Categories and Structures

Principles of Economics, Taxation and Agrarian Reform 14


Market Categories and Structures

Examples of Monopolists

Principles of Economics, Taxation and Agrarian Reform 15


Market Categories and Structures

C. Monopolistic Competition
Monopolistic competition refers to a market situation with a relatively large number of
sellers offering similar but not identical products, hence, are not perfect substitutes. In
monopolistic competition, a firm takes the prices charged by its rivals as given and ignores
the impact of its own prices on the prices of other firms.

Monopolistic competition as a market structure was first identified in the 1930s by American
economist Edward Chamberlin and English economist Joan Robinson.

1. Characteristics Perfectively Competitive Market

Monopolistically competitive markets exhibit the following characteristics:

a. Relatively Small Number of Firms

Compared to perfect competition, the number of firms under monopolistic


competition is lesser. Each firm makes independent decisions about price and
output, based on its product, its market, and its production cost. Knowledge is
widely spread between participants. The seller has a more significant role than in
firms that are perfectly competitive because of the increased risks associated with
decision making.

b. Freedom of Entry or Exit

There is freedom to enter or leave the market, as there are no major barriers to
entry or exit but the firm has no power to restrict the entry of new firms. Since
many firms in the monopolistic competition market are small sized and are
capable of producing substitutes, they can easily leave or enter the industry in the
long run.

Principles of Economics, Taxation and Agrarian Reform 16


Market Categories and Structures

c. Product Differentiation

Product differentiation means that products are different in some aspects. They
are heterogeneous rather than homogeneous so each firm has an absolute
monopoly in the production and sale of the differentiated product.

A central feature of monopolistic competition is that products are differentiated.


There are four main types of differentiation:
 Physical product differentiation, where firms use size, design, color, shape,
performance, and features to make their products different.
 Marketing differentiation, where firms try to differentiate their product by
distinctive packaging and other promotional techniques.
 Human capital differentiation, where the firm creates differences through
the skill of its employees, the level of training received, distinctive
uniforms, and so on.
 Differentiation through distribution, including distribution via mail order or
through internet shopping,

d. More Elastic Demand

Firms are price makers and are faced with a more elastic downward sloping
demand curve. The firm can set its own price and does not have to ‘take’ it from
the industry as a whole, though the industry price may be a guideline, or a
constraint. Monopolistically competitive firms are assumed to be profit
maximizers because firms tend to be small with entrepreneurs actively involved in
managing the business.

e. Competitive Advertising

Firms operating under monopolistic competition usually have to engage in


competitive advertising. Firms are often in fierce competition with other (local)
firms offering a similar product or service and may need to advertise on a local
basis to let customers know their differences. Common methods of advertising for
these firms are through local press and radio, local cinema, posters, leaflets and
special promotions.

f. Product Groups
There is no any “industry” under monopolistic competition, rather a “group” of
firms producing similar products. Each firm produces a distinct product and is
itself an industry. Firms producing closely related products comprise the “product
group.”

g. Selling Cost
Since products are differentiated, the monopolistically competitive firm incurs
selling costs to increase sales. This includes advertisements, salesmen salary and

Principles of Economics, Taxation and Agrarian Reform 17


Market Categories and Structures

allowances, free service, free sampling, coupons, expenses for window displays,
among others.

2. Price and Output Determination under Monopolistic Competition


Monopolistic competition in the short run
Based on the graph below, profit maximization is where MC = MR, and output is Q and price
is P. At that price, the average revenue curve (AR) is above the average total cost curve
(ATC) at Q. The area of PABC shows the possible supernormal profits of the firm.

Supernormal profit is defined as extra profit above that level of normal profit. Supernormal
profit occurs where AR>ATC. It is also known as abnormal profit, an incentive for other
firms to enter the industry. Normal profit, on the other hand, refers to the minimum level of
profit necessary to keep a firm in that line of business and occurs when Average Revenue
AR=ATC (average total cost).

As new firms enter the market, demand for the existing firm’s products becomes
more elastic and the demand curve shifts to the left, driving down price. Eventually, all
super-normal profits are eroded away.

Principles of Economics, Taxation and Agrarian Reform 18


Market Categories and Structures

Monopolistic competition in the long run


Super-normal profits attract in new entrants, which shifts the demand curve for existing firm
to the left. New entrants continue until only normal profit is available. At this point, firms
have reached their long run equilibrium.

The firm benefits most when it is in its short run and will try to stay in the short run by
innovating and further product differentiation.

3. Advantages of monopolistic competition


The existence of monopolistic competition partly explains the survival of small firms in
modern economies. The majority of small firms in the real world operate in markets that
could be said to be monopolistically competitive. Monopolistic competition can bring the
following advantages:
 There are no significant barriers to entry; therefore, markets are open to interested
new entrants
 Differentiation creates diversity, choice and utility to the benefit of consumers.
 The market is more efficient than monopoly but less efficient than perfect
competition - less allocatively and less productively efficient.

Principles of Economics, Taxation and Agrarian Reform 19


Market Categories and Structures

Examples of Monopolistic Products

Principles of Economics, Taxation and Agrarian Reform 20


Market Categories and Structures

D. Oligopoly

The term oligopoly was derived from two Greek words: “oligoi” meaning a few and
“pollein” meaning to sell. Oligopoly is a market situation with few enough sellers of
homogeneous or differentiated products.

1. Classification of Oligopoly

a. Based on Product Differentiation


 Pure or Perfect Oligopoly - products of the firms are homogeneous or identical
 Imperfect or Differentiated Oligopoly – products of firms are differentiated

b. Based on Entry of Firms


 Open Oligopoly – complete freedom for new entrants to the industry. There is no
restriction or barrier to entry.
 Closed Oligopoly – new firms are not allowed to enter

c. Based on Price Leadership


 Partial Oligopoly - market situation where the industry is dominated by one large firm
known as the leader and the other firms (the followers) of the industry follow the
price policy determined by the leader.
 Full Oligopoly – market situation where there is no leader and no followers.

d. Based on Agreement
 Collusive Oligopoly – a market situation where the firms of the industry follow a
common pricing policy. They combine together to avoid competition among
themselves regarding price and output of the industry.
 Non-Collusive Oligopoly – a market situation where there is no agreement among the
firms, hence each firm acts independently.

2. Characteristics of Oligopoly

a. Very few sellers of the product


The number of sellers dealing in homogenous or differentiated product is very small
that the pricing and output policy of the individual firm can influence the industry
price and output. Each firm controls a large share of the market. Hence, changing its
output will make a noticeable effect on market activities.

b. Interdependence
An oligopolist has to take into consideration the actions and reactions of other
oligopolists in its pricing and output determination. The cross price elasticity of
demand for their products is very high because of the availability of close substitutes.
This is also the reason why firms do not normally like to change their prices and
output levels.

Principles of Economics, Taxation and Agrarian Reform 21


Market Categories and Structures

c. Presence of monopoly power


Since the number of firms in the oligopoly market is few, collusion among them is
possible. Collusion is a secret agreement or cooperation especially for an illegal or
deceitful purpose. Under collusion, the firms act as monopoly and they may charge
higher prices for their products.

d. Existence of price rigidity


In oligopoly, each firm has to stick to its price. If an oligopolist raises its price, its
rival will not follow suit, as keeping their prices constant will lead to an increase in
market share. On the other hand, if an oligopolist lowers its price, its rivals will be
forced to follow suit to prevent a loss of market share. Hence, no firm would like to
change its price, resulting to price rigidity.

e. Excessive expenditure on advertisement


With many close substitutes for their product and interdependence, the firm has to
stick to its prevailing price. To increase sales and market share, oligopolists have to
make improvement in the quality of its products and resort to advertisements. Each
firm tries to attract as many customers possible through the costly advertisements.

3. Price and Output Determination Under Oligopoly

The interdependence of the demand curves of firms in oligopoly makes it difficult to


establish a theory of determination of prices and outputs. According to American
economist William J. Baumol, the firm may adopt any of the following approaches:

a. Ignoring interdependence
The firm may just disregard interdependence and make its own decisions as to pricing
and quantity, but it must also be expected that other oligopolists will protect their own
interest. Profit maximization is the common objective of the firms.

b. Estimating the competitor’s countermoves


Based on past experiences, the firm may try to estimate the anticipated actions and
reactions of their competitors.

c. Preparing against optimal moves by the competitors


The firm calculates the optimal moves of its competitors’ strategies and prepares its
own defenses and countermoves. This approach is associated with the game theory.

4. Kinked Demand Curve

The kinked demand curve suggests firms have little incentive to increase or decrease
prices or the earlier discussed price rigidity. In theory, the kinked demand curve
suggests an explanation for why prices are stable.

Principles of Economics, Taxation and Agrarian Reform 22


Market Categories and Structures

If a firm increases its price, it becomes uncompetitive. It results to reduction in


demand for its product, showing that demand is price elastic for a higher price. This
means increasing price would lead to a fall in revenue.

However, if firm decreases price, they would gain market share. It is assumed in this
situation other firms also do not want to lose market share, hence they also cut prices
too. Therefore, for a price cut, demand is price inelastic.

Problems with Kinked demand Curve Model

1. Empirical evidence to support this model is very weak. Prices do change in


oligopolistic markets much more often than this model suggests.
2. The kinked demand curve doesn’t say why prices were reached in the first
place.
3. Oligopoly makes assumptions about the behavior of firms in response to price
changes that firms in reality may not make.

Principles of Economics, Taxation and Agrarian Reform 23


Market Categories and Structures

Examples of Oligopolists

Principles of Economics, Taxation and Agrarian Reform 24


Market Categories and Structures

REFERENCES:

Agarwal, H.S., (2013). Principles of Economics 8th Edition.Global Professional Publishing


Ltd.

Mankiw, G.N., (2012). Essentials of Economics 6th Edition. Harvard University: South-
Western, Cengage Learning

C. et.al (2012). Economics: Principles, Problems, and Policies (Global Edition). McGraw
Hill Co., Inc.

Paraiso O.C. et.al (2011). Introduction to Microeconomics, Mutya Publishing House, Inc.

http://www.businessdictionary.com
http://www.economicsonline.co.uk/Business_economics/Monopolistic_competition.html
http://economicsconcepts.com/
www.economicsonlinetutor.com
http://ec.europa.eu/competition/consumers/why_en.html
http://beta.tutor2u.net/economics/reference/monopoly-price-and-output-for-a-monopolist
hthttp://www.intelligenteconomist.com/
http://www.investopedia.com
http://.images.search.yahoo.com.

Principles of Economics, Taxation and Agrarian Reform 25


Introduction to
Macroeconomics

Circular Flow of Economic Activity


Economic Growth and Business Cycle
Learning Objectives
•Differentiate macroeconomics and
microeconomics

•Explain the relationships among the different


sectors of the economy through the “circular flow
of economic activity” diagram

• Correlate the business cycle and economic


growth
Division of Economics
Microeconomics is the study of particular markets, and
segments of the economy. It tackles issues on consumer
behavior, individual labor markets, and the theory of
firms.
The branch of economics that deals with the
performance, structure and behavior of the economy of
the entire community, either a nation, a region, or the
entire world.
MACROECONOMICS vs MICROECONOMICS

AREA MICROECONOMICS MACROECONOMICS

Approach Bottoms-up Top - down


Focus/Scope of Individuals and Country and
Decision business decisions government decisions

Goods and Supply and demand; Industries as a whole


Services effects of prices on and the entire economy
consumer behavior and
production theory

Issues Studied Theory of supply and Gross domestic product


demand and the (GDP) and the national
factors of production debt; inflation,
employment
Microeconomics concerns:
• Supply and demand in individual markets
• Concentrates on the ‘ups’ and ‘downs’ of the
markets for goods and services
• Consumer behavior, and methods of
determining the supply and demand of the
market.
• Externalities arising from production and
consumption.
Macroeconomics concerns:

 Monetary / fiscal policy. e.g. what effect does


interest rates have on whole economy?
 Reasons for inflation, and unemployment
 Economic Growth
 International trade and globalization
 Reasons for differences in living standards and
economic growth between countries.
 Government borrowing
Circular Flow of Economic Activity
Circular Flow of Economic Activity
Circular Flow of Economic Activity
Economic Growth
and
Business Cycle
What is economic growth?
• An increase in an economy’s total output of goods
and services.
Gross Domestic Product (GDP)
Economic growth is measured quarterly
using real GDP to compensate for the effects of
inflation.

GDP is defined as the value of the goods and


services generated within a country.

It measures the overall economic output of a


country.
Impact of Economic Growth
 Creation of new jobs and lower
unemployment
 Improved living standards
 Increased profits
 Increased capital investments
 Improved business confidence
 Increased tax revenues for government
GDP Composition
GDP = C + I + G + (X-M)
Where:
GDP = Gross Domestic Product
C = Consumption Expenditures
I = Investment
G = Government Expenditures
X = Import
M = Import
Growth Rates of Gross National Income and Gross Domestic Product
by Expenditure Shares, Philippines
1st Quarter 2014 and 2015 and Annual 2013-2014
(at constant 2000 prices)
1st Quarter Annual
TYPE OF EXPENDITURE
2013-14 2014-15 2012-13 2013-14
1. Household Final Consumption Expenditure 6.1 5.4 5.6 5.4
2. Government Final Consumption Expenditure 1.9 4.8 5.0 1.7
3. Capital Formation* 12.8 11.8 27.7 5.4
A. Fixed Capital 1.7 10.1 12.2 6.8
1. Construction -1.0 5.7 11.0 10.9
2. Durable Equipment 4.0 14.3 15.5 3.7
3. Breeding Stock & Orchard Dev't -4.4 0.1 -4.0 -0.7
4. Intellectual Property Products 13.0 14.8 16.4 19.7
4. Exports 12.7 1.0 -1.0 11.3
A. Exports of Goods 14.6 1.2 -0.4 12.8
B. Exports of Services 6.6 0.4 -3.3 5.3
5. Less : Imports 16.3 4.6 4.4 8.7
A. Imports of Goods 16.8 2.5 3.6 8.6
B. Imports of Services 14.6 11.9 7.5 9.1

GROSS DOMESTIC PRODUCT 5.6 5.2 7.1 6.1


GROSS NATIONAL INCOME 6.6 4.7 8.1 5.8

* Capital formation includes fixed capital and changes in inventories


Source: Philippine Statistics Authority
Consumption is the amount that households
spend on new goods and services
Investment (I) is the amount that
households and businesses spend on items that
are used to make more goods and services or
capital goods.
Government Expenditures involve the
government spending for goods and services.
Business Cycle

The business cycle is the four phases of economic


growth and subsequent decline. It is also called as the
economic cycle and the boom and bust.
Economy at Different Stages of the Business Cycle
Boom/Peak High levels of consumer spending, profits
and investments. Low unemployment
level. Cost and Inflation rise faster
Recession/ Falling levels of consumer spending lead
Trough to lower profits, hence cut back on
investment; rising unemployment
Slump/ Weak consumer spending and business
Recession investment; close shop, rapidly rising
unemployment level; falling prices
Recovery Consumer spending starts to increase,
start investments ; regain employment
but on a slow pace
References
Mankiw, G.N., (2012). Essentials of Economics 6th Edition. Harvard
University: South-Western, Cengage Learning
McConnel, C. et.al (2012). Economics: Principles, Problems, and Policies
(Global Edition). McGraw Hill Co., Inc.
Stock, W.A., (2013). Introduction to Economics : Social Issues and
Economic Thinking . Montana State University. Wiley.

Intenet Web Sites:


http://www.differencebetween.net/
http://economics.about.com/
http://www.ehow.com
https://ph.images.search.yahoo.com
http://www.investopedia.com/
http://www.slideshare.net
Introduction to Macroeconomics

8
Introduction to Macroeconomics
“Macroeconomics deals not with individual quantities, as such but with aggregates of these
quantities: not with individual incomes’ but with national income; not with individual prices,
but with price level; not with individual outputs, but with national output. Macroeconomics is
that part of the subject, which deals with the great aggregates and averages of the system
rather than a particular item in it, and attempts to define these aggregates in a useful manner
and to examine their relationship.”
Kenneth E. Boulding, Economist, Educator

Objectives:

After studying this chapter, the students should be able to:

1. Differentiate macroeconomics and microeconomics


2. Explain the relationships among the different sectors of the economy through the
“circular flow of economic activity” diagram
3. Correlate the business cycle and economic growth

I. Definition of Macroeconomics
Ragnar Frisch, a Norwegian economist coined and used the term microeconomics and
macroeconomics in 1933. Micro and macro were derived from Greek words micros meaning
small and macros meaning large.

Economists Rudiger Dornbusch and Stanley Fischer state that “Macroeconomics is


concerned with the behavior of the economy as a whole – with booms and recessions, the
economy’s total output of goods and services and the growth of output, the rates of inflation
and unemployment, the balance of payments and exchange rate. Macroeconomics deals with
long run economic growth and with short run fluctuations that constitute the business cycle.”

II. Comparison between Microeconomics and Macroeconomics

Principles of Economics, Taxation and Agrarian Reform 1


Introduction to Macroeconomics

Microeconomics is the study of particular markets, and segments of the economy. It tackles
issues on consumer behavior, individual labor markets, and the theory of firms.
Microeconomics is concerned with:

 Supply and demand in individual markets


 Concentrates on the ‘ups’ and ‘downs’ of the markets for goods and services
 Consumer behavior and methods of determining the supply and demand of the
market.
 Externalities arising from production and consumption

Macroeconomics, on the other hand, deals with the performance, structure and behavior of
the economy of the entire community, of a nation, a region, or the entire world and is
concerned with:
 Monetary/fiscal policy. e.g., what effect does interest rates have on whole economy?
 Reasons for inflation and unemployment
 Economic Growth
 International trade and globalization
 Reasons for differences in living standards and economic growth between countries.
 Government borrowing

Principles of Economics, Taxation and Agrarian Reform 2


Introduction to Macroeconomics

AREA MICROECONOMICS MACROECONOMICS


Approach Bottoms-up Top - down
Focus/Scope of Individuals and business decisions Country and government decisions
Decision

Goods and Services Supply and demand; effects of Industries as a whole and the
prices on consumer behavior and entire economy
production theory

Issues Studied Theory of supply and demand and Gross domestic product (GDP)
the factors of production and the national debt; inflation,
employment

Importance of Macroeconomics

 The study of macroeconomics is necessary for us to understand how an economy


works. It helps us to understand and analyze the performance of an economy.
 Macroeconomics is a great help in the development of economic theories and
formulation of economic policies geared towards economic growth.
 It is helpful in the computation of the national income and analysis of the problems
relating to national income like inflation, deflation and unemployment.
 Guides in the study of general level of taxation and public expenditure.
 Macroeconomics provides necessary information in comparing economies of
different countries.

III. Circular Flow and National Income


The circular flow of income and spending shows the linkages between the different
sectors of macroeconomy. The circular flow model is a conceptual framework which
facilitates understanding of the macroeconomic activities. The importance of the
circular flows is as follows:

1. Calculation of National Income: The circular flow helps in calculating


national income through flow of funds accounts showing all monetary
transactions in the economy, highlighting on the links between savings and
investments and lending and borrowings.

2. Creation of Markets: The circular flow explains the link between the
producers and consumers.

3. Formulation of Trade Policies: The circular flow of money helps the


government in coming up with strategies aimed at promoting and increasing
exports and the reduction of imports. It should be noted that exports are
considered injections and imports are leakages in the circular flow.

Principles of Economics, Taxation and Agrarian Reform 3


Introduction to Macroeconomics

4. Role of Monetary Policy: Monetary policy is concerned with managing the


amount of money in circulation. Increase or decrease in money supply
brought about by savings and investments are shown in the circular flow.
Policy makers have to set policies aimed at establishing equilibrium between
savings and investment. A decrease in the amount of available money or
credit in an economy leads to deflation or causes prices to go down.
Correspondingly, inflation or a continuing rise in the general price level will
be experienced which is attributed to an increase in the volume of money and
credit relative to available goods and services.

5. Role of Fiscal Policy: Fiscal policy is the means by which a government


adjusts its spending levels and tax rates to monitor and influence a nation's
economy. It is in consonance with the monetary policy through which a
central bank influences a nation's money supply. Government spending on
goods and services is an injection into the circular flow while savings and
taxes are leakages.

6. Level of Economic Activity: Leakages and injections affect the economic


activities of the country. If leakages are more than the injections, the level of
employment and income, for example, would decrease and vice versa. An
injection is an addition to the income of households that does not arise from
the spending of domestic firms, or an addition to the income of the firms that
does not arise from the spending of the households. Income from abroad and
borrowing from banks are examples of injections. Savings, imports, taxes and
undistributed profits of firms are leakages from the circular flow.

When leakages equal injections, equilibrium is attained and the circular flow
remains undisturbed. If injections exceed leakages, there is economic
prosperity and the circular flow grows, while in the reverse there would be
recession causing the circular flow to shrink.

Principles of Economics, Taxation and Agrarian Reform 4


Introduction to Macroeconomics

IV. Circular Flow Models


An economic model is a simplified description of reality, designed to yield
hypotheses about economic behavior that can be tested. According to David N.
Hyman, author of many economic books, “A model is like a schematic drawing of a
complex mechanism that attempts to show what happens when various levers or
buttons are pressed.” The economic model is a tool to investigate “cause and effect”
relationships.

1. Two-Sector Model Without Savings

2. Two-Sector Model with Savings and Investment

Principles of Economics, Taxation and Agrarian Reform 5


Introduction to Macroeconomics

3. Circular Flow of Income in a Three-Sector Economy

4. Circular Flow in a Four-Sector Economy

Principles of Economics, Taxation and Agrarian Reform 6


Introduction to Macroeconomics

5. Circular Flow in a Five-Sector Economy

Principles of Economics, Taxation and Agrarian Reform 7


Introduction to Macroeconomics

V. Business Cycle

The business cycle is the four phases of economic growth and subsequent decline.
It is also called as the economic cycle and the boom and bust. Business cycle is
also termed as “trade cycle” by some economists like John Maynard Keynes in his
Treatise on Money defining that a trade cycle is composed of periods of goods
trade characterized by rising prices and low unemployment percentages, altering
with periods of bad trade characterized by falling prices and high unemployment
percentages.

Another economist, Robert Aaron Gordon in his book Business Fluctuations stated
that, “business cycles consist of recurring alternation of expansion and contraction
in aggregate economic activity, the alternating movements in each direction being
self-reinforcing and pervading virtually all parts of the economy.”

A. Phases of Business Cycle

Normally the business cycle is divided into four phases as shown below:

A business cycle starts from the trough, a period in which there is little economic activity
and prices are usually low, passes through recovery and prosperity phase rises to a peak,
decline through a recession and depression phases and again reaches a trough.

Recovery Phase

During depression, the businessmen postpone replacement of their equipments and


consumers defer their spending on the purchase of durable goods. When prices are
low, consumers start to purchase capital goods and so the level of output increases,
leading to increase in employment. With this, aggregate demand will also increase.

Principles of Economics, Taxation and Agrarian Reform 8


Introduction to Macroeconomics

Prosperity Phase

During this phase, businesses are doing well. The economy operates on full economy.
The level of employment is and the volume of production is large; the price level
tends to be rising, so with interest rates; investment spending is at high level, the GDP
increases and credit expansion is at its peak. Economic activity is at its height, idle
resources are few and unemployment rate is low.

Recession

A recession is a general downturn in any economy. A recession is associated with


high unemployment, slowing gross domestic product, and high inflation. Factors that
cause recession are:
a) High interest rates are a cause of recession because they limit liquidity,
or the amount of money available to invest.
b) Inflation refers to a general rise in the prices of goods and services over a
period of time. As inflation increases, the percentage of goods and
services that can be purchased with the same amount of money decreases.
c) Reduced consumer confidence. When consumers believe the economy is
bad, they are less likely to spend money. Consumer confidence is
psychological but can have a real impact on any economy.

Depression

A depression is an unusual and extreme form of recession where there is a general


decline in economic activity. There is reduction in production of goods and services,
employment, income, demand and prices. Credit expansion declines because the
businessmen are not willing to borrow even if interest rates are low.

Depression is characterized by mass unemployment and general fall in prices, profits,


wages, interest rate, consumption, expenditure, investment, bank deposits and loans;
factories close down; and construction of buildings and infrastructures come to a
standstill.
Economy at Different Stages of the Business Cycle

Phase Characteristics
Recession/ Falling levels of consumer spending lead to lower
Trough profits, hence cut back on investment; rising
unemployment
Boom/Peak High levels of consumer spending, profits and
investments. Low unemployment level. Cost and
inflation rise faster
Slump/ Weak consumer spending and business investment; close
Recession shop, rapidly rising unemployment level; falling prices
Recovery Consumer spending starts to increase, start investments ;
regain employment but on a slow pace

Principles of Economics, Taxation and Agrarian Reform 9


Introduction to Macroeconomics

VI. Employment

A. Theories of Employment

In economics, full employment refers to an economic condition in which


every individual is employed. It signifies the market condition where the
demand for labor is equivalent to the supply of labor at every level of real
wage. Full employment is the employment level at which every individual
who desires to work at the prevalent wage rate gets employed.

1. Classical Theory of Employment by Adam Smith

The classical theory of employment was based upon two basic


assumptions 1) that there is always enough expenditure or aggregate
demand to purchase the total production at full-employment level of
resources; and 2) that even when deficiency of aggregate expenditure or
demand arises, the prices and wages would change in such a way that
real production, employment and income will not decline.

The classical thought that there was no problem of deficiency of expen-


diture and demand was based upon Say’s law of markets which states
that every production of goods also creates incomes equal to the value of
goods produced and these incomes are spent on purchasing these. Say is
a French economist of the 19th century.

The main points of criticism of classical theories are as follows:


a. States that supply creates its own demand that is not possible if
certain part of income is saved and aggregate revenue is not always
equal to aggregate cost
b. Considers that the employment can be increased by decreasing the
wage rate, which is not true in the real world
c. Assumes that rate of interest helps in maintaining equilibrium
between savings and investments, which is not true in practical
applications
d. Infers that the economy can be adjusted on its own and it does not
require any government intervention, which is not possible
e. Considers that the wages and prices are very much flexible, which is
not true in the real world economy
f. Regards money as a medium of exchange only; however, money
plays an important role in the economy
g. Fails to explain the occurrence of trade cycles.

Principles of Economics, Taxation and Agrarian Reform 10


Introduction to Macroeconomics

2. Keynesian or Modern Theory of Employment by John Maynard


Keynes

The theory explains that employment is triggered by the aggregate


demand for goods and services. When the demand for goods and
services increases, production will correspondingly increase, resulting to
more employment.

B. Categories of Unemployment

1. Seasonal Unemployment
Seasonal unemployment occurs in regular patterns, usually on an
annual basis, and is caused by predictable changes in demand.
Seasonal unemployment occurs on a more or less fixed and
predictable basis, as it is caused by shifts in demand that depend on
the time of year. Seasonal unemployment is actually a type
of structural unemployment as the structure of the economy changes
on a seasonal basis and demand for workers changes accordingly.

2. Frictional Unemployment

Frictional unemployment is temporary unemployment associated with


adjustments in a changing dynamic. It results from imperfect or
incomplete information and the difficulties in matching qualified
workers with jobs. A college graduate who is actively looking for
work is one example.

3. Structural Unemployment

Structural unemployment refers to unemployment that occurs when


workers are not qualified for the jobs that are available. Workers in
this case are often out of work for much longer periods of time and
often require retraining. Structural unemployment can be a serious
problem within an economy, particularly in cases where entire sectors
(manufacturing, for instance) become obsolete.

4. Cyclical Unemployment

Cyclical unemployment refers to unemployment that is a product of


the business cycle. Cyclical unemployment is caused by the lack of
demand that is a consequence of business cycle downturns. During
recessions, there is often inadequate demand for labor and wages and
are typically slow to fall to a point where the demand and supply of
labor are back in balance. Businesses facing lower demand have

Principles of Economics, Taxation and Agrarian Reform 11


Introduction to Macroeconomics

lower revenues and usually have to reduce their costs to prevent


taking losses; frequently, this is done by laying off workers. When the
economy begins to expand and demand returns to former levels,
employers need those workers again.

5. Disguised or Concealed Unemployment

A situation where people who are out of work are not counted in
official unemployment statistics. Potential workers falling into this
category include individuals who have given up looking for jobs, those
who have taken an early retirement and those with seasonal or part
time employment. The non-inclusion of concealed unemployment in
overall unemployment numbers allows for a higher perceived rate of
employment.

VII. Consumption and Savings Functions

Consumption is that part of income that is spent on goods and services


yielding direct satisfaction.

The consumption function is a mathematical formula laid out by famed


economist John Maynard Keynes. The formula was designed to show the
relationship between real disposable income and consumer spending, the
latter variable being what Keynes considered the most important determinant
of short-term demand in an economy.

The Keynesian Consumption function expresses the level of consumer


spending depending on three factors.

Principles of Economics, Taxation and Agrarian Reform 12


Introduction to Macroeconomics

 Yd = disposable income (income after tax)


 a = autonomous consumption (consumption when income is zero. (e.g.
even with no income, you may borrow to be able to buy food))
 b = marginal propensity to consume (the % of extra income that is
spent).

Consumption function formula: C = a + b Yd

This shows that consumption is primarily determined by the level of disposable income (Yd),
where higher disposable income would lead to higher consumer spending.

At low incomes, people will spend a high proportion of their income or even spend
everything they have. With low income, one may not be able to save, since he needs to spend
for the basic needs. However, as incomes rise, people can afford the luxury of saving a
higher proportion of their income. Therefore, as income rise, spending increases at a lower
rate than disposable income. People with high incomes have a lower average propensity to
spend.

Implications of Consumption Function

If you cut income tax for those on low income, they tend to have a higher marginal
propensity to consume this extra income. Therefore, there is a large increase in spending.
People with high incomes will tend to have a lower marginal propensity to consume. If they
benefit from a tax cut, they will save a greater proportion.

Principles of Economics, Taxation and Agrarian Reform 13


Introduction to Macroeconomics

Shift in the Consumption Function

In this diagram, the consumption function has shifted upwards (to the left (C1 to C2). This
means consumers are spending a higher % of their income. This could be due to a rise in
property prices which increases consumer confidence and lead to higher consumer spending.

Increased marginal propensity to consume

In this diagram, the consumption function has become steeper. This means the value of b
(MPC) has increased. Therefore, people are spending a higher % of their additional income.
This could be due to rising confidence, lower saving and easier availability of credit.

Principles of Economics, Taxation and Agrarian Reform 14


Introduction to Macroeconomics

Other theories of consumption

1. Permanent income hypothesis (Milton Friedman). A theory that a person’s


consumption is determined, not just by current income, but also future expected
income. It suggests that consumers will attempt to ‘smooth consumption’ over their
lifetime, e.g. borrowing as a student, running down savings in retirement.
2. Life cycle hypothesis (Richard Brumberg & Franco Modigliani). Another theory that
people attempt to smooth consumption over their lifecycle. This suggests that
spending will be dependent on current income, future expected income, and also a
function of wealth.

Consumption and Savings Function

According to the Keynesian consumption function, savings are positively related to the
level of disposable income. At low levels of income, total spending may exceed income
causing dis-saving. As income rises, total savings rise - the gradient of the savings
function is given by the marginal propensity to save.

Principles of Economics, Taxation and Agrarian Reform 15


Introduction to Macroeconomics

Marginal Propensity to save is the proportion of an aggregate raise in pay that a consumer
spends on saving rather than on the consumption of goods and services. Marginal
propensity to save is a component of Keynesian macroeconomic theory and is calculated
as the change in savings divided by the change in income.

change in saving

Marginal propensity to save =

change in income

MPS is depicted by a savings line: a sloped line created by plotting change in savings on
the vertical y axis and change in income on the horizontal x axis.

VIII. Investment and Multiplier Effect

Investment (I) is the amount that households and businesses spend on items that are
used to make more goods and services or capital goods.

Principles of Economics, Taxation and Agrarian Reform 16


Introduction to Macroeconomics

The multiplier effect is an economic term referring to how an increase in one economic
activity can cause an increase throughout many other related economic activities as shown by
the diagram below:

Principles of Economics, Taxation and Agrarian Reform 17


Introduction to Macroeconomics

References:

Agarwal, H.S., (2013). Principles of Economics 8th Edition.Global Professional Publishing


Ltd.

Kennedy, M.J., (2012). Macroeconomic Theory.Aseoke K. Ghosh, PHI, Learning Private


Limited

Mankiw, G.N., (2012). Essentials of Economics 6th Edition. Harvard University: South-
Western, Cengage Learning

McConnel, C. et.al (2012). Economics: Principles, Problems, and Policies (Global Edition).
McGraw Hill Co., Inc.

Stock, W.A., (2013). Introduction to Economics : Social Issues and Economic Thinking .
Montana State University. Wiley.

http://www.differencebetween.net
http://economics.about.com/
http://www.economicshelp.org
http://www.ehow.com
https://www.google.com.ph
https://ph.images.search.yahoo.com
http://www.imf.org/external/pubs/ft/fandd/2011/06/basics.htm
http://www.investopedia.com/
http://www.merriam-webster.com/
http://www.slideshare.net
http://study.com/academy/lesson

Principles of Economics, Taxation and Agrarian Reform 18


Gross Domestic Product
Approaches to Measuring
GNP
•Expenditure Approach
•Value- Added Approach

•Income Approach
Learning Objectives

• Discuss the Philippine System of National Account

• Differentiate the methods of computing for the Gross Domestic


Product

• Possess a deeper and a clearer understanding in explaining the


performance of the economy
 Gross Domestic Product refers to the
value of all goods and services produced
domestically; the sum of gross value
added of all resident institutional units
engaged in production (plus any taxes, and
minus any subsidies, on products not
included in the values of their outputs).

 GDP measures the value of all goods and


services produced WITHIN A
COUNTRY regardless of the nationality of
the people who supplied the goods or
services.
Gross National Product (GNP), which measures
output from the citizens and companies of a
particular nation, regardless of whether they are
located within its boundaries or overseas.

 GNP measures the value of all goods


and services produced BY A
COUNTRY in a given year regardless of
whether these goods or services are
produced within the country or outside
the country.
Gross National Income comprises the total
value of goods and services produced within a
country (i.e. its Gross Domestic Product),
together with its income received from other
countries (notably interest and dividends),
less similar payments made to other
countries.
The System of National Accounts (SNA)
provides a systematic statistical
framework for summarizing and
analyzing the economic flows and
wealth of an economy.
Purposes of SNA
• Assessment of economic performance;
• Gauging the impact of government policies and other factors
(via supply and use and input-output tables), including those
from abroad;
• Formulation of economic targets in terms of ratios, such as tax
revenue to GDP, government deficit and debt to GDP, current
account deficit/surplus to GDP; and,
• Identification of causal relationships between variables and
the support of economic models;
• Allows the user to focus on particular parts of the economy
thru the data on institutional sector and activity by industry.
Joint Philippine -American Finance Commission starts
1947 1938-1946
estimation of National Accounts in the Philippines
Central Bank assumes National Income (NI) estimation 1950 1948-1950

First attempt at constant price estimation (1949=100) 1954 1954

Consolidated Accounts I. GDP + Expenditures 1955 1946 to present


Consolidated Accounts II. National Disposable Income & its
1955 1946 to present
Appropriation
Consolidated Accounts III. Gross Accumulation 1955 1946 to present

Consolidated Accounts IV. External Transaction 1955 1946 to present


1946-1979(no
Income & Outlay Account I. Private Corporation 1955
disaggregation)
1980 to present
Income & Outlay Account II. Government Corporation 1980 (disaggregated into priv.
and gov't. corp.)
Income & Outlay Account III. General Government 1955 1946 to present

Income & Outlay Account IV. Household 1955 1946 to present

National Economic Council (NEC) assumes NI estimation 1957 1956 to present

1st revision of National Accounts, 1967 base year 1968 1946-1967

Direct and Indirect Taxes 1968 1967 to present

Start of Semestral National Accounts 1972 1967-1972


National Economic and Development Authority (NEDA)
1973 1973-1987
continues NI estimation
2nd revision and rebasing from 1967 to 1972 of NI
1976 1946-1975
Accounts

Quarterly National Accounts 1983 1981-1982

National Statistical Coordination Board (NSCB) assumes


the estimation of the PSNA

3rd revision and rebasing of PSNA (1972 to 1985) 1990 1946 to present

Sub-Account I. Factor Shares by Institution 1990 1980 to present

Sub-Account II. Relations Among National Accounts


1990 1946 to present
Aggregates

Principal Indicators 1990 1946 to present

Regional Accounts

GRDP 1974 1971-1974

GRDE 1987 1975-1987

Deseasonalized National Accounts Series 1993 1988-1993

Confidence Interval Estimates 1996 1996 to present


Basic Concepts
The current PSNA basically follows the 1968 UN System
National Account (SNA) but to a limited scale
incorporates the recommendations of the 1993 SNA.

Transactors are economic units called institutional


units. The institutional sectors in the present PSNA are :
•Private Corporations
•Government Corporations
•General Government; and
•Households, including non-profit institutions
serving households and unincorporated
enterprises..
Basic Concepts
 Economic Territory does not coincide exactly with
geographic territory

 Total economy consists of all institutional units that


are residents of the country

 An institutional unit is said to be resident of a


country when it has a center of economic interest in
the economic territory of country - that is when it
engages for an extended period (one year or more
being taken as a practical guide) in economic
activities of this territory
Salient Features of the 1993 SNA
 With more articulations introduced in the classifications and institutional
sectoring, compilers and users have more flexibility in prioritizing various
parts of the accounts, depending on the analysis required and data
availability.

 Harmonized with other international statistical systems such as the Balance of


Payment (BOP), International Labour Organization (ILO), Government Finance
Statistics (GFS), and Money and Banking Statistics (MBS)

 More articulated accounts to address concerns such as the revaluation


account that record changes in prices or inflation
Salient Features of the 1993 SNA
 Introduce the concept of Gross Domestic Income and the concept of Gross
National Income (GNI) to replace Gross National Product (GNP). GNI (at
constant prices) is equal to GDP (at constant prices) plus Trading Gains/Loss
from changes in the terms of trade plus NFIA (at constant prices)
 Introduce the concepts of mixed income and primary income
 Delineation of output into market output, output for own final use and non-
market output.
 Provision of guidelines for the compilation of satellite accounts such as
environmental, tourism, education and transportation accounts.
Comparison of the 1993 SNA and the Current PSNA

1993 SNA CURRENT ANNUAL PSNA


Institutional Sectors Institutional Sectors
a. financial a. private corporations
b. non-financial b. government corporations
c. general government c. general government
d. households d. households including NPISHs and
e. non-profit institution serving unincorpotated enterprises.
households.

Accumulation Account Only the capital account for the whole


1. Capital Account economy is covered. A matrix
2. Financial Account presentation of the financial account
3. Other Changes in Volume of Assets (Flow of Funds) is being compiled by
Account the BSP.
4. Revaluation

Mixed Income for unincorporated No distinction between operating


enterprises owned by households surplus and mixed income
- remuneration for work done by the
owner of the enterprise as well as a
return to entrepreneurship
Comparison of the 1993 SNA and the Current PSNA

Gross National Income (GNI) Uses GNP but GNI is found in the
memo item on the main table of
the national accounts at constant
prices

Military expenditures (except on Treated as current expenditure


weapons) are part of capital
formation

Valuables which are held as Treated as current expenditure


stores of values are capital
expenditures

Financial leasing is treated as To the extent that data can


capital formation while support, distinction between
operational leasing is treated as operational and financial leasing
services are considered.
Special Data Dissemination Standard (SDDS) of the
International Monetary Fund (IMF)

Item IMF STANDARD PHILIPPINES


Coverage The SDDS does not GDP by expenditure and
characteristics prescribe specific industry, GNP, current
components of the national and constant 1985 prices,
accounts; rather it implicit deflators, growth
prescribes either GDP by rates
productive sector
(industry), or expenditure
shares or both.

Periodicity Quarterly Quarterly


Timeliness one quarter after the for Q1 to Q3 the time lag
reference period is two months while Q4 is
one month after the
reference period.
Advance Advance dissemination of Schedule of releases of
dissemination of release dates that may be the National Accounts is
release calendar taken published every January.
Production Approach

Gross Output
less:
Intermediate Inputs
equals:
Gross Value Added (GVA)
Agriculture, Fishery & Forestry
1.1 Sources of Data:
Agricultural Crops
Bureau of Agricultural Statistics
• Rice & Corn Survey (RCS)
• Farm Price Survey (FPS)
Sugar Regulatory Administration
Philippine Coconut Authority
• Farm Price Survey (FPS)
Livestock & Poultry
Bureau of Agricultural Statistics
• Survey of commercial Livestock/Poultry Farms
• Survey of backyard Livestock/Poultry Farms
• Survey of animals slaughtered in Abattoirs
• Farm Price Survey (FPS)
Agriculture, Fishery & Forestry
1.1 Sources of Data:
Agricultural Activities & Services
National Irrigation Administration (NIA)
Fertilizers & Pesticides Authority (FPA)
National Statistics Office (NSO)
•Census of Agriculture
•Annual Survey of Establishments
Fishery
Bureau of Agricultural Statistics
•Survey of commercial fishing
•Survey of municipal fishing
•Survey of aquaculture farms
Forestry
Forest Management Bureau (FMB)
National Statistics Office (NSO)
•Survey of Wholesale Price
1.2 Methodology for Production Approach

Estimation Methodology at Current Prices


Estimation Methodology
at Constant Price
Preliminary Revised

Direct Estimation: same as preliminary but uses Direct Estimation:


updated data
GVA = Q x P x GVAR GVA = Q x P x GVAR
where P is the current where P is the base year
price for the period price
Expenditure Approach

Where:

C = household consumption expenditures /


personal consumption expenditures
I = gross private domestic investment
G = government consumption and gross investment
expenditures
X = gross exports of goods and services
M = gross imports of goods and services
2. Manufacturing Sector
2.1 Sources of Data
Census & Surveys of the NSO
Census of Establishments (CE)
Annual Survey of Establishments (ASE)
Quarterly Survey of Establishment (QSE)
Survey of Key Enterprises in Manufacturing
(SKEM)
Integrated Survey of Households (ISH)
Wholesale Price Index (WPI)

Department of Trade & Industry (DTI)


Survey of Manufacturing Enterprises
2. Manufacturing Sector
2.1 Sources of Data
NSCB - NSO
Input-Output Table
Administrative Data
Department of Energy (DOE)
The Philippine Cement Manufacturers Corporation
(Philcemcor)
Sugar Regulatory Administration (SRA)
Philippine Associated Smelting and Refining
Corporation (PASAR)
2.2 Methodology Expenditure Approach:
GVA Quarterly Estimates
* At Current Prices:
where:
GVAqt = GVA at quarter q of year t
GVAqt-1 = GVA at quarter q of the preceding year
Xqt = production at quarter q of year t
Xqt-1 = production at quarter q of the
preceding year

* At Constant Prices:
GVAqt = GVA at current prices / Deflator
Income Approach

Compensation of Employees
plus:
Depreciation
plus:
Indirect Taxes - Subsidies
plus:
Net Operating Surplus
equals:
Gross Domestic Product
Growth Rates of Gross National Income and Gross Domestic Product
1st Quarter 2014 and 2015 and Annual 2013-2014
(at constant 2000 prices)
Source: Philippine Statistics Authority
1st Quarter Annual
INDUSTRY
2013-14 2014-15 2012-13 2013-14
1. AGRI., HUNTING, FORESTRY AND
0.6 1.6 1.1 1.6
FISHING
a. Agriculture and forestry 1.4 2.5 1.2 2.0
b. Fishing -3.1 -2.6 0.7 -0.4
2. INDUSTRY SECTOR 5.4 5.5 9.2 7.9
a. Mining & Quarrying 9.0 7.1 1.2 4.9
b. Manufacturing 7.0 5.9 10.3 8.3
c. Construction 1.0 4.5 10.3 9.9
d. Electricity, Gas and Water Supply 0.3 4.1 3.6 2.8
3. SERVICE SECTOR 6.8 5.6 7.0 5.9
a. Transport, Storage & Communication 8.2 8.6 6.0 6.2
b. Trade and Repair of Motor Vehicles,
6.1 5.4 6.2 5.7
Motorcycles, Personal and Household Goods
c. Financial Intermediation 5.7 4.3 12.6 7.2
d. R. Estate, Renting & Business Activities 10.2 6.4 8.8 8.7
e. Public Administration & Defense;
6.3 0.2 2.7 3.6
Compulsory Social Security
f. Other Services 4.3 5.8 5.2 3.3

GROSS DOMESTIC PRODUCT 5.6 5.2 7.1 6.1


GROSS NATIONAL INCOME 6.6 4.7 8.1 5.8
Growth Rates of Gross National Income and Gross Domestic Product
by Expenditure Shares
1st Quarter 2014 and 2015 and Annual 2013-2014
(at constant 2000 prices)
* Capital formation includes fixed capital and changes in inventories
Source: Philippine Statistics Authority
1st Quarter Annual
TYPE OF EXPENDITURE
2013-14 2014-15 2012-13 2013-14
1. Household Final
6.1 5.4 5.6 5.4
Consumption Expenditure
2. Government Final Consumption
1.9 4.8 5.0 1.7
Expenditure
3. Capital Formation* 12.8 11.8 27.7 5.4
A. Fixed Capital 1.7 10.1 12.2 6.8
1. Construction -1.0 5.7 11.0 10.9
2. Durable Equipment 4.0 14.3 15.5 3.7
3. Breeding Stock & Orchard Dev't -4.4 0.1 -4.0 -0.7
4. Intellectual Property Products 13.0 14.8 16.4 19.7
4. Exports 12.7 1.0 -1.0 11.3
A. Exports of Goods 14.6 1.2 -0.4 12.8
B. Exports of Services 6.6 0.4 -3.3 5.3
5. Less : Imports 16.3 4.6 4.4 8.7
A. Imports of Goods 16.8 2.5 3.6 8.6
B. Imports of Services 14.6 11.9 7.5 9.1

GROSS DOMESTIC PRODUCT 5.6 5.2 7.1 6.1


GROSS NATIONAL INCOME 6.6 4.7 8.1 5.8
Expenditures - Exports and Imports
Source : Foreign Trade Statistics,
National Statistics Office
Frequency : Monthly
Time Lag : 30 days after reference month
Disaggregation : 7-digit level of PSCC

Estimation Methodology Deflators /


Expenditure
Constant
Item Preliminary Revised
Price Estimation
a. Merchandise Exports: FOB $value same as preliminary Unit value in the base
multiplied by midpoint but uses updated period
exchange rate data
Imports: CIF $ value
multiplied by midpoint
multiplied by midpoint
Both are corrected for
returned goods &
temporarily exported/
imported goods
b. Non-factor
1. Exports Direct estimation: BOP data same as preliminary WPI & CPI
multiplied by midpoint but uses updated
exchange rate data
2. Imports Direct estimation: BOP data same as preliminary CPI & Foreign
multiplied by midpoint but uses updated exchange rates of
exchange rate data selected trading
partners
3. Net Factor Income from Abroad
Estimation Methodology Estimation
Income Flow at Current Prices Methodology
Preliminary Revised at Constant Price
Inflow
Compensation Total stock of OFW x same as preliminary
average salary x but uses updated data
average forex
Property Income Investment income same as preliminary
from BOP x average but uses updated data
forex
Total Inflow Total inflow at current
prices is deflated using
the composite implicit
price indices of PCE,
GGCE, GFCF
Outflow
Compensation Personal income from same as preliminary
BOP x average forex but uses updated data

Property Expense Investment expense same as preliminary


from BOP x average but uses updated data
forex
Net Factor Income Inflow - Outflow same as preliminary Inflow-outflow is deflated
but uses updated data using composite price
index of PCE, GGCE,
Gross Fixed Capital
Formation
References

http://www.investordictionary.com/
http://www.investopedia.com/
http://www.nscb.gov.ph/
http://philippinecapital.com/
https://www.psa.gov.ph/
National Income Accounting

9
National Income Accounting
GDP, GNI, GNP are words we normally associate with national income accounting, an accounting
system that the national government uses to measure the level of the country’s economic activity in
a given period. National income accounting is not an exact science, but it provides useful insight
into how well an economy is functioning. It gives us indicators on how well or bad the country’s
economy is. It also provides the quantitative information on which a government bases its planning,
policies and forecasting for growth and development on.

Objectives:

After studying this chapter, the students should be able to:

1. Differentiate the methods of computing for the Gross Domestic Product


2. Possess a deeper and a clearer understanding in explaining the performance of the
economy
3. Discuss the Philippine System of National Account

What is National Income Accounting?

National Income Accounting is a method of preparing and presenting national income accounts and
provides the standards by which economic activity of a country could be assessed. National income
accounting records the level and facilitates the measurement of macroeconomic aggregates like
gross domestic product (GDP), gross national product (GNP) and gross national income (GNI).

There are five main components of national income accounting:


1. Production account deals with the business sector of the economy and comprises all firms of
production, such as trading and manufacturing.
2. Capital accounts show that there is an equilibrium between foreign and domestic investment
3. Consumption accounts refer to the receipts and payments of the household sector, which
consists of nonprofit organizations and consumers
4. Foreign transactions accounts show various transactions between a country and other
countries of the world.
5. Government account reflects the inflows and outflows of the government.

Importance and Uses of National Income Accounting

Principles of Economics, Taxation and Agrarian Reform 1


National Income Accounting

1. It indicates performance of the economy, signifying economy’s strength and failures.


2. It helps to find out structural changes in the economy, i.e. the share of the agricultural
sector in the Philippine GDP is declining overtime.
3. It reflects how national income is shared among various factors of production.
4. It measures the welfare of the citizens of a country and can be used to compare the
standard of living which leads us to make suitable changes in plans and approaches to
achieve rapid economic development. The higher per capita income indicates a higher
level of welfare.
5. National income statistical data reflect the specific contribution of individual sectors and
their growth over time.
6. It is helpful to United Nations Organization (UN) which formulates welfare plans for
different countries, especially for underdeveloped and developing countries.
7. It provides a rich source of information and bases for economic policy and research.

There are generally three approaches in measuring the National Income Accounting: 1)
expenditure approach which adds up what has been bought during a period, 2) the
income approach which adds up what has been earned during a period, and 3) the value-added or
industrial origin approach.

Gross Domestic Product (GDP)

GDP is the total market value of all final goods and services produced in a country in a given year.
There are three things to be taken into account in the definition:

 GDP measures the total market value. It is necessary to convert everything in peso value to
have a uniform measure.
 GDP measure final goods and services or those final products ready to be consumed to
avoid double counting which could lead to a bloated and erroneous GDP.
 GDP counts only those goods and services produced within a country.

To calculate GDP, we multiply the price and quantity of each good and service to get the value, and
then add up all the values.

GDP = ∑ PiQi

Where Pi = price of ith commodity in the given year

Qi = quantity of production of ith commodity in the given year

Nominal/Current GDP vs. Real GDP

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National Income Accounting

The above formula shows that we use prices to measure the value of goods and services produced.
Considering the current prices to value current would give us the nominal or current GDP.
However, it can be noted that the change in the nominal GDP can also be attributed to a change in
the production of goods and services. Thus, it is possible that the nominal GDP will increase even if
production has not changed at all due to increase in prices giving an inaccurate account of the
country’s economic performance. It also makes it difficult to compare production from year to year,
since prices change every year.

To better gauge the economic performance of the country and to avoid misleading interpretation of
the GDP, another measure of GDP that takes price changes into account will be used and will be
termed as Real GDP. Values of goods and services in any given year are based on the prices of a
set base period. By holding prices constant, real GDP measures only the changes in production
from year to year. Changes in real GDP are used to measure economic growth.

Real GDP is GDP adjusted for inflation and can be derived by dividing current GDP by a price
index also known as a deflator.

Real GNP = Current GNP x 100%


Price Index

Price Index

A price index is constructed by taking the weighted average of the prices of a basket of goods in a
given year divided by the weighted average of the prices of the same basket in a base year. A well
known price index is the consumer price index or CPI.

The National Statistics Office had prepared a primer on Consumer Price Index containing the
following information.

What is the Consumer Price Index (CPI)?

The CPI is an indicator of the change in the average retail prices of a fixed basket of goods and
services commonly purchased by households relative to a base year.

What are the uses of CPI?

The CPI is most widely used in the calculation of the inflation rate and purchasing power of the
peso. It is a major statistical series used for economic analysis and as a monitoring indicator of
government economic policy. The CPI is also used to adjust other economic series for price
changes. For example, CPI components are used as deflators for most personal consumption
expenditures (PCE) in the calculation of the gross national product (GNP). Another major

Principles of Economics, Taxation and Agrarian Reform 3


National Income Accounting

importance of the CPI is its use as basis to adjust wages in labor management contracts as well as
pensions and retirement benefits. Increases in wages through collective bargaining agreements use
the CPI as one of their bases

How is the CPI computed?

The computation of the CPI involves consideration of the following important points:

a) Base Period.
Since the CPI measures the average changes in the retail prices of a fixed basket of
goods, it is necessary to compare the movement in prices in the current year to
movements in previous years back to a reference date at which the index is taken as
equal to 100. This reference date or base period is simply a convenient benchmark to
which a continuous series of index can be related and has no numerical significance.
The base period is a year. A month is deemed unwise to use as a base period because
it often reflects accidental or seasonal influences. The present series uses 2006 as the
base year. The year 2006 was chosen as the base year because it is the year when the
Family Income and Expenditure Survey (FIES) was conducted. The FIES is the
basis of the CPI weights. It is also in accordance with the National Statistical
Coordination Board Resolution Number 2, Series of 2009, which approves the
synchronized rebasing of the price indices to base year 2006.

b) Market Basket.
Since it is virtually impossible to have periodic measures on the changes in the
prices of all the thousands of varieties of goods purchased for consumption and
services availed of by households in the country, a sample of these items, known as
the `CPI market basket’, was selected to represent the composite price behavior of
all goods and services purchased by consumers.

The market basket used in the construction of the 2006- based CPI for all income
households combines the baskets of the upper 70% and bottom 30% income group
households drawn from the results of the 2007-2008 Commodity and Outlet Survey
(COS).

The COS is a nationwide survey of households undertaken by the National Statistics


Office (NSO). This is conducted for the purpose of gathering data on commodities
and services that a family purchased/ consumed/availed of most of the times and the
type of outlets where these commodities/services were purchased/availed of within
the country.

The 2006 CPI series is also the first in the CPI series that used the United Nations
Classification of the Individual Consumption According to Purpose (COICOP) in
determining the commodity groupings of the items and services included in the
market basket. There are 80 provincial market baskets including the National Capital
Region (NCR) and the cities of Isabela and Cotabato.

c) Weighting System.

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National Income Accounting

A desirable system should consider the relevance of the components of the index.
For the CPI, the weighting pattern uses the expenditures on various consumer items
purchased by households as a proportion to total expenditure.

The weights of the eleven COICOP divisions used in the computation of the CPI are shown
in the following table.
CONSUMER PRICE INDEX (CPI)
Weights by Commodity Group for CPI (2006=100)

Areas
Division Philippines NCR Outside
NCR
All Items 100.00 23.79 76.21
01 FOOD AND NON-ALCOHOLIC BEVERAGES 38.98 6.72 32.20
02 ALCOHOLIC BEVERAGES AND TOBACCO 1.99 0.33 1.66
03 CLOTHING AND FOOTWEAR 2.96 0.74 2.22
04 HOUSING, WATER, ELECTRICITY, GAS AND OTHER 22.46 6.97 15.49
FUELS
05 FURNISHING, HOUSEHOLD EQUIPMENT AND 3.22 0.84 2.38
ROUTINE MAINTENANCE OF THE HOUSE
O6 HEALTH 2.99 0.64 2.35
O7 TRANSPORT 7.81 1.86 5.95
08 COMMUNICATION 2.26 0.71 1.55
09 RECREATION AND CULTURE 1.93 0.50 1.43
10 EDUCATION 3.37 0.76 2.61
11 RESTAURANT AND MISCELENEOUS GOODS AND 12.03 3.66 8.37
SERVICES
These weights were derived from the 2006 FIES.

d. Formula.

The formula used in computing the CPI is the weighted arithmetic mean of price
relatives, the Laspeyre’s formula with a fixed base year period (2006) weights.

e. Geographic Coverage.
CPI values are computed at the national, regional, and provincial levels, and for
selected cities. A separate CPI for NCR is also computed.

What is the purchasing power of the peso?


The purchasing power of the peso shows how much the peso in the base period is
worth in the current period. It is computed as the reciprocal of the CPI for the
period under review multiplied by 100.
What agencies are responsible for the generation of the CPI?
The NSO and the Bureau of Agricultural Statistics (BAS) collect price data for the
index. The BAS is responsible for collecting prices for agricultural commodities in
NCR and in the provinces covered by its responsibilities. The NSO, on the other
hand, collects prices for the non-agricultural commodities all over the country.

Principles of Economics, Taxation and Agrarian Reform 5


National Income Accounting

Moreover, the NSO does all the price collections for all the commodities in areas
not covered by BAS. The NSO computes the CPI.

How often is the CPI released?

The CPI is computed by the NSO on a monthly basis. It is available five days after
the reference month.

What is the inflation rate?


The inflation rate is the annual rate of change or the year-on year change of the CPI
expressed in percent. Inflation is interpreted in terms of declining purchasing power
of money.

Year-on-Year Inflation Rates in the Philippines, All Items


First Quarter 2007 - Second Quarter 2015

Year
Quarter
2007 2008 2009 2010 2011 2012 2013 2014 2015

1st 3.4 6.9 12.3 4.2 4.6 2.7 3.5 5.7 3.1

2nd 2.8 14.3 5.5 3.5 5.4 2.4 3.1 6.5 2.1

3rd 2.7 19.3 0.2 3.7 5.2 3.1 3.5 6.8

4th 4.1 15.1 3.4 3.1 5.2 3.0 4.8 5.1

Average 3.3 13.9 5.4 3.6 5.1 2.9 3.7 6.0

Principles of Economics, Taxation and Agrarian Reform 6


National Income Accounting

II. Gross National Product (GNP)


Gross National Product (GNP) measures the output from the citizens and companies of a
particular nation, regardless of whether they are located within its boundaries or overseas.
GNP measures the value of all goods and services produced BY A COUNTRY in a given
year regardless of whether these goods or services are produced within the country or
outside the country.

The gross national product can be calculated through the expenditure approach, the income
approach and value-added approach. The GNP excludes intermediate goods, second hand
sales, as well as financial transactions. The GNP is a money amount and must be adjusted
for changes in the value of money. Intermediate goods are goods which are made part of
some final good. Incorporating intermediate goods to form a final good adds value to that
good.

The goal of the GNP is to measure physical activity of the country by adding all the values
of the different types of production.

III. Measuring GDP and GNP:

A. The Expenditure Approach

GDP can be calculated as the sum of all expenditures: personal consumption expenditure (C),
gross private domestic investment (I), government purchases (G), and net exports (X- IM).
GDP = C + I + G + X – IM
• Consumption (C). Personal Consumption Expenditure covers what the households buy:
durables (cars, appliances), nondurables (clothing, food) and services (education, doctor
visits, airline tickets). Durable goods include furniture, appliances, equipment, cars, etc.
Nondurable goods are all items which would normally be consumed within a year: food,
fuel, stationary, and by convention also clothing.

 Investment (I). Investments include 1) new construction, 2) new capital (machines, trucks
and equipment), and 3) changes in inventory. It excludes investment made by government
and investment made outside the country. New construction includes all forms of new
building, be it for rental purpose or for private residential purpose. Changes in inventory
captures the goods produced in one year and sold in future years.

 Government Spending (G): Includes all national and local government purchases of goods
and services from paper clips to roads, bridges, hospital, schools and other infrastructures.

 Net Exports (X - IM). Net exports are the difference between total exports and total imports.
It is equal to the balance of payments (BOP). For the past years the Philippines is net
importer wherein the value of the imports is higher than that of the exports. Exports are all
items produced by the country which are sold to other countries. Imports are items produced
by other countries and brought in to the Philippines.

Principles of Economics, Taxation and Agrarian Reform 7


National Income Accounting

GROSS NATIONAL INCOME AND GROSS DOMESTIC PRODUCT


BY TYPE OF EXPENDITURE: Annual 2013 and 2014
AT CURRENT AND CONSTANT 2000 PRICES, IN MILLION PESOS

At Current Prices At Constant Prices


TYPE OF EXPENDITURE Growth Growth
2013 2014 Rate 2013 2014 Rate
(%) (%)
1. Household Final
Consumption 8,463,826 9,156,446 8.2 4,692,438 4,947,000 5.4
Expenditure
2. Government Final
Consumption 1,250,814 1,314,482 5.1 705,811 718,096 1.7
Expenditure

3. Capital Formation 2,313,405 2,643,871 14.3 1,487,902 1,568,346 5.4


A. Fixed Capital 2,369,292 2,627,172 10.9 1,441,475 1,539,125 6.8
1. Construction 1,261,129 1,436,803 13.9 586,731 650,615 10.9
2. Durable Equipment 885,836 975,857 10.2 720,937 747,910 3.7
3. Breeding Stock &
177,593 162,767 -8.3 96,063 95,411 -0.7
Orchard Dev't
4. Intellectual
44,735 51,745 15.7 37,744 45,189 19.7
Property Products
B. Changes in
-55,886 16,699 46,428 29,221
Inventories

4. Exports 3,232,795 3,623,352 12.1 3,024,867 3,365,953 11.3


A. Exports of Goods 2,104,278 2,387,344 13.5 2,417,822 2,726,442 12.8
B. Exports of Services 1,128,516 1,236,009 9.5 607,045 639,511 5.3

5. Less: Imports 3,718,554 4,095,414 10.1 3,160,940 3,435,378 8.7


A. Imports of Goods 2,914,119 3,185,022 9.3 2,501,608 2,716,287 8.6
B. Imports of Services 804,435 910,392 13.2 659,332 719,091 9.1

6. Statistical
0 0 0 0
Discrepancy

GROSS DOMESTIC
11,542,286 12,642,736 9.5 6,750,079 7,164,017 6.1
PRODUCT

Net Primary Income 2,506,986 2,684,599 1,418,689 1,476,628

GROSS NATIONAL
14,049,272 15,327,336 9.1 8,168,768 8,640,645 5.8
INCOME
HOUSEHOLD FINAL CONSUMPTION EXPENDITURE
Annual 2013 and 2014
AT CURRENT AND CONSTANT 2000 PRICES, IN MILLION PESOS

ITEMS At Current Prices At Constant Prices

Principles of Economics, Taxation and Agrarian Reform 8


National Income Accounting

Growth Growth
2013 2014 Rate 2013 2014 Rate
(%) (%)
HOUSEHOLD FINAL
CONSUMPTION 8,463,826 9,156,446 8.2 4,692,438 4,947,000 5.4
EXPENDITURE

1. Food and Non-alcoholic


3,602,777 3,870,513 7.4 1,963,521 2,054,488 4.6
beverages
2. Alcoholic beverages, Tobacco 110,059 126,588 15.0 63,540 70,094 10.3
3. Clothing and Footwear 116,635 127,205 9.1 75,625 79,742 5.4
4. Housing, water, electricity,
1,062,100 1,139,379 7.3 519,375 542,339 4.4
gas and other fuels
5. Furnishings, household
equipment and routine 326,101 350,161 7.4 249,442 261,555 4.9
household maintenance
6. Health 222,833 255,163 14.5 109,462 123,165 12.5
7. Transport 894,369 1,002,999 12.1 385,344 426,471 10.7
8. Communication 264,863 276,202 4.3 251,544 259,582 3.2
9. Recreation and culture 154,391 165,846 7.4 108,269 113,863 5.2
10. Education 331,844 364,078 9.7 144,937 152,403 5.2
11. Restaurants and hotels 318,553 345,168 8.4 195,181 208,068 6.6
12. Miscellaneous goods and
1,059,301 1,133,144 7.0 626,197 655,230 4.6
services
Source: Philippine Statistics Authority
Posted: 27 August 2015

GOVERNMENT FINAL CONSUMPTION EXPENDITURE


Annual 2013 and 2014
AT CURRENT AND CONSTANT 2000 PRICES, IN MILLION PESOS

At Current Prices At Constant Prices


TYPE OF
Growth Growth
EXPENDITURE
2013 2014 Rate 2013 2014 Rate
(%) (%)
Government
Final
1,250,814 1,314,482 5.1 705,811 718,096 1.7
Consumption
Expenditure

GROSS DOMESTIC CAPITAL FORMATION BY TYPE


Annual 2013 and 2014
AT CURRENT AND CONSTANT 2000 PRICES, IN MILLION PESOS

TYPE OF EXPENDITURE At Current Prices At Constant Prices

Principles of Economics, Taxation and Agrarian Reform 9


National Income Accounting

Growth Growth
2013 2014 Rate 2012 2012 Rate
(%) (%)
Capital Formation 2,313,405 2,643,871 14.3 1,487,902 1,568,346 5.4
A. Fixed Capital 2,369,292 2,627,172 10.9 1,441,475 1,539,125 6.8
1. Construction 1,261,129 1,436,803 13.9 586,731 650,615 10.9
2. Durable Equipment 885,836 975,857 10.2 720,937 747,910 3.7
3. Breeding Stock &
177,593 162,767 -8.3 96,063 95,411 -0.7
Orchard Dev't
4. Intellectual Property
44,735 51,745 15.7 37,744 45,189 19.7
Products
B. Changes in Inventories -55,886 16,699 46,428 29,221
Source: Philippine Statistics Authority

EXPORTS OF SERVICES
Annual 2013 and 2014
AT CURRENT AND CONSTANT 2000 PRICES, IN MILLION PESOS

At Current Prices At Constant Prices


ITEMS Growth Growth
2013 2014 Rate 2013 2014 Rate
(%) (%)
EXPORTS OF
1,128,516 1,236,009 9.5 607,045 639,511 5.3
SERVICES

Transportation 69,368 77,334 11.5 31,059 34,762 11.9


Insurance 1,441 1,688 17.2 780 878 12.5
Travel 202,087 232,376 15.0 109,888 121,221 10.3
Government 12,454 13,894 11.6 7,003 7,568 8.1
Miscellaneous
843,167 910,717 8.0 458,315 475,082 3.7
services
Source: Philippine Statistics Authority
Posted: 27 August 2015

EXPORTS
Annual 2013 and 2014
AT CURRENT AND CONSTANT 2000 PRICES, IN MILLION PESOS

TYPE OF At Current Prices At Constant Prices

Principles of Economics, Taxation and Agrarian Reform 10


National Income Accounting

EXPENDITURE Growth Growth


2013 2014 Rate 2013 2014 Rate
(%) (%)
Exports 3,232,795 3,623,352 12.1 3,024,867 3,365,953 11.3
A. Exports of
2,104,278 2,387,344 13.5 2,417,822 2,726,442 12.8
Goods
B. Exports of
1,128,516 1,236,009 9.5 607,045 639,511 5.3
Services
Source: Philippine Statistics Authority
Posted: 27 August 2015

EXPORTS OF GOODS
Annual 2013 and 2014
AT CURRENT AND CONSTANT 2000 PRICES, IN MILLION PESOS

At Current Prices At Constant Prices


ITEMS Growth Growth
2013 2014 Rate 2013 2014 Rate
(%) (%)
TOTAL EXPORTS OF
2,104,278 2,387,344 13.5 2,417,822 2,726,442 12.8
GOODS

Principal Exports of Goods 1,306,282 1,440,847 10.3 1,566,309 1,705,020 8.9

Electronic Components 872,172 988,076 13.3 1,259,976 1,397,360 10.9


Components/Devices
643,680 695,402 8.0 985,302 1,062,713 7.9
(Semiconductors)
Electronic Data
121,982 163,990 34.4 151,692 188,260 24.1
Processing
Office Equipment 22,758 35,693 56.8 22,998 32,297 40.4
Consumer Electronics 13,493 15,798 17.1 22,044 25,938 17.7
Telecommunication 14,571 16,962 16.4 20,134 24,088 19.6
Communication/Radar 8,670 11,966 38.0 11,551 16,419 42.1
Control
22,606 34,978 54.7 24,834 35,484 42.9
Instrumentation
Medical/Industrial
1,890 3,637 92.4 2,009 4,146 106.4
Instrumentation
Automotive
22,523 9,650 -57.2 19,412 8,015 -58.7
Electronics

Principal Agricultural
127,887 148,034 15.8 73,934 66,611 -9.9
Products
Bananas, including
Plantains, Fresh or 41,256 51,401 24.6 25,174 27,348 8.6
Dried
Coconut Oil 36,898 51,875 40.6 17,846 18,413 3.2
Copra Oil Cake or Meal 9,565 6,226 -34.9 4,996 2,160 -56.8

Principles of Economics, Taxation and Agrarian Reform 11


National Income Accounting

Dessicated Coconut 8,492 11,613 36.8 4,788 4,729 -1.2


Mango, Fresh or Dried 2,448 4,546 85.7 1,277 2,552 99.8
Pineapple and
17,455 18,321 5.0 7,258 7,202 -0.8
Pineapple Products
Sugar 11,774 4,052 -65.6 12,596 4,207 -66.6

Principal Fishery
29,946 22,232 -25.8 22,187 14,255 -35.7
Products
Shrimps and Prawns 2,320 3,989 72.0 1,950 2,832 45.3
Tuna 27,626 18,243 -34.0 20,237 11,423 -43.6

Articles of Apparel and


68,129 83,060 21.9 63,398 77,454 22.2
Clothing Accessories
Basketworks 2,429 3,099 27.6 2,710 2,737 1.0
Cathodes & Sections of
Cathodes, of Refined 27,024 18,587 -31.2 6,826 3,517 -48.5
Copper
Ignition Wiring Sets 69,224 85,184 23.1 60,967 72,353 18.7
Metal Components 73,617 73,760 0.2 66,312 65,657 -1.0
Other Products
Manufactured from
- - - - - -
Materials on
Consignment Basis
Petroleum Products 35,853 18,815 -47.5 9,999 5,076 -49.2

Others 797,996 946,497 18.6 851,513 1,021,422 20.0


Source: Philippine Statistics Authority
Posted: 27 August 2015

IMPORTS
Annual 2013 and 2014
AT CURRENT AND CONSTANT 2000 PRICES, IN MILLION PESOS

TYPE OF At Current Prices At Constant Prices

Principles of Economics, Taxation and Agrarian Reform 12


National Income Accounting

EXPENDITURE Growth Growth


2013 2014 Rate 2013 2014 Rate
(%) (%)
Imports 3,718,554 4,095,414 10.1 3,160,940 3,435,378 8.7
A. Imports of
2,914,119 3,185,022 9.3 2,501,608 2,716,287 8.6
Goods
B. Imports of
804,435 910,392 13.2 659,332 719,091 9.1
Services
Source: Philippine Statistics Authority
Posted: 27 August 2015

IMPORTS OF GOODS
Annual 2013 and 2014
AT CURRENT AND CONSTANT 2000 PRICES, IN MILLION PESOS

At Current Prices At Constant Prices


ITEMS Growth Growth
2013 2014 Rate 2013 2014 Rate
(%) (%)
TOTAL IMPORTS OF
2,914,119 3,185,022 9.3 2,501,608 2,716,287 8.6
GOODS

A. PRINCIPAL IMPORT
2,097,357 2,201,739 5.0 1,821,463 1,862,154 2.2
GOODS

1. Electronics 402,356 344,972 -14.3 741,933 628,631 -15.3


Components/Devices
216,550 159,177 -26.5 496,403 378,628 -23.7
(Semiconductors)
Electronic Data
75,571 74,370 -1.6 162,611 165,053 1.5
Processing
Office Equipment 4,966 4,620 -7.0 3,578 3,165 -11.6
Consumer Electronics 19,554 19,592 0.2 11,066 11,239 1.6
Telecommunication 46,628 47,813 2.5 35,026 35,939 2.6
Communication/Radar 25,153 26,303 4.6 21,809 23,998 10.0
Control
8,600 7,433 -13.6 7,500 6,431 -14.2
Instrumentation
Medical/Industrial
4,636 4,655 0.4 3,505 3,549 1.3
Instrumentation
Automotive
699 1,010 44.5 436 629 44.5
Electronics
2. Mineral fuels 608,779 641,573 5.4 196,598 210,298 7.0
3. Machinery and
179,322 195,281 8.9 139,698 152,581 9.2
mechanical appliances
4. Base metals 91,369 112,783 23.4 50,856 64,713 27.2
5. Transport equipment 321,092 364,745 13.6 302,894 344,986 13.9
6. Textile yarns 38,365 38,892 1.4 51,576 63,084 22.3
7. Electrical machinery 57,564 65,005 12.9 70,464 79,488 12.8
8. Artificial resins 67,813 97,240 43.4 55,812 78,094 39.9

Principles of Economics, Taxation and Agrarian Reform 13


National Income Accounting

9. Chemical products 59,869 60,403 0.9 37,296 37,230 -0.2


10. Cereals 61,930 84,897 37.1 49,228 74,222 50.8
11. Dairy Products 40,555 44,241 9.1 18,819 20,000 6.3
12. Medical and
48,120 48,096 -0.1 44,311 46,336 4.6
Pharmaceutical products
13. Paper products 33,398 37,628 12.7 33,311 35,168 5.6
14. Feedstuff 46,132 57,490 24.6 17,215 24,792 44.0
15. Metalliferous ores and
40,692 8,492 -79.1 11,452 2,530 -77.9
metal scrap

B. OTHERS 816,762 983,284 20.4 680,144 854,134 25.6


Source: Philippine Statistics Authority
Posted: 27 August 2015

IMPORTS OF SERVICES
Annual 2013 and 2014
AT CURRENT AND CONSTANT 2000 PRICES, IN MILLION PESOS

At Current Prices At Constant Prices


ITEMS Growth Growth
2013 2014 Rate 2013 2014 Rate
(%) (%)
IMPORTS OF
804,435 910,392 13.2 659,332 719,091 9.1
SERVICES

Transportation 136,590 141,512 3.6 113,245 112,475 -0.7


Insurance 12,088 12,418 2.7 10,742 10,483 -2.4
Travel 472,334 507,044 7.3 375,666 386,261 2.8
Government 11,102 12,374 11.4 9,501 10,106 6.4
Miscellaneous
172,321 237,044 37.6 150,178 199,766 33.0
services
Source: Philippine Statistics Authority
Posted: 27 August 2015

PER CAPITA: GROSS DOMESTIC PRODUCT, GROSS NATIONAL INCOME, HOUSEHOLD


FINAL CONSUMPTION EXPENDITURE
Annual 2013 and 2014
AT CURRENT AND CONSTANT 2000 PRICES, IN PESOS
Growth
TYPE OF EXPENDITURE 2013 2014
Rate

Principles of Economics, Taxation and Agrarian Reform 14


National Income Accounting

(%)

A. Estimates in current pesos


1. Gross Domestic Product 117,543 126,579 7.7
2. Gross National Income 143,073 153,457 7.3
3. Household Final Consumption
86,193 91,674 6.4
Expenditure

B. Estimates in constant (2000)


pesos
1. Gross Domestic Product 68,741 71,726 4.3
2. Gross National Income 83,188 86,510 4.3
3. Household Final Consumption
47,786 49,529 3.6
Expenditure

C. Population (million
98.2 99.9
persons)
Source: Philippine Statistics Authority
Posted: 27 August 2015

DETAILS OF FACTOR FLOWS FROM AND TO THE REST OF THE WORLD


Annual 2013 and 2014
AT CURRENT AND CONSTANT 2000 PRICES, IN MILLION PESOS

At Current Prices At Constant Prices


ITEMS Growth Growth
2013 2014 Rate 2013 2014 Rate
(%) (%)
Net Primary
2,506,986 2,684,599 7.1 1,418,689 1,476,628 4.1
Income

INFLOW
Compensation 2,758,252 2,964,567 7.5 1,560,895 1,630,603 4.5
Property
55,871 67,963 21.6 31,671 37,381 18.0
Income
Total 2,814,123 3,032,531 7.8 1,592,565 1,667,984 4.7

OUTFLOW
Compensation 0 0 - 0 0 -
Property
307,137 347,931 13.3 173,876 191,356 10.1
Expense
Total 307,137 347,931 13.3 173,876 191,356 10.1
Source: Philippine Statistics Authority

B. The Income Approach

Principles of Economics, Taxation and Agrarian Reform 15


National Income Accounting

The second approach to measuring GDP is the income approach which adds up what has been
earned during a period. Computation is based on the following formula:

Compensation of Employees
plus:
Depreciation
plus:
Indirect Taxes - Subsidies
plus:
Net Operating Surplus
equals:
Gross Domestic Product

The income components include among others the following:

 Compensation of employees – includes wages and salaries earned by households, fringe


benefits, private pensions and welfare funds.
 Corporate profits – includes profits of all private corporations
 Proprietors income – refers to the net profits of unincorporated businesses and self-
employed professionals
 Rental income of persons – income in the form of rent and royalties from the ownership
of properties.
 Interest – income received by households and government from capital
 Indirect business taxes are all the various sales and excise taxes – sales taxes are the
largest part of indirect business taxes. These sales taxes are paid as an addition to the
price when a purchase is made. They are passed on to the government by the business
that collects them. Thus, these money are not part of what is distributed by the firm in
the form of income
 Depreciation - the amount of capital that has worn out during the year

Principles of Economics, Taxation and Agrarian Reform 16


National Income Accounting

C. Value-Added or Industrial Origin Approach.

This measure of GDP considers the difference between the market value of all goods and
services produced and the cost of all the goods and materials produced by other producers. It
is the net contribution of the firm to the total value of production

GROSS NATIONAL INCOME AND GROSS DOMESTIC PRODUCT


BY INDUSTRY: Annual 2013 and 2014
AT CURRENT AND CONSTANT 2000 PRICES, IN MILLION PESOS

At Current Prices At Constant Prices


INDUSTRY/INDUSTRY Growth Growth
GROUP 2013 2014 Rate 2013 2014 Rate
(%) (%)
Agriculture, Hunting,
1,297,151 1,428,131 10.1 706,586 717,824 1.6
Forestry and Fishing
Industry Sector 3,595,720 3,968,897 10.4 2,219,124 2,394,694 7.9
Service Sector 6,649,415 7,245,708 9.0 3,824,369 4,051,499 5.9

GROSS DOMESTIC
11,542,286 12,642,736 9.5 6,750,079 7,164,017 6.1
PRODUCT
Net Primary Income 2,506,986 2,684,599 1,418,689 1,476,628
GROSS NATIONAL
14,049,272 15,327,336 9.1 8,168,768 8,640,645 5.8
INCOME
Source: Philippine Statistics Authority
Posted: 27 August 2015

GROSS VALUE ADDED in AGRICULTURE, HUNTING, FORESTRY & FISHING


Annual 2013 and 2014
AT CURRENT AND CONSTANT 2000 PRICES, IN MILLION PESOS

At Current Prices At Constant Prices


INDUSTRY/INDUSTRY
Growth Growth
GROUP
2013 2014 Rate 2013 2014 Rate
(%) (%)
1. AGRICULTURE,
HUNTING and 1,097,830 1,230,996 12.1 575,583 587,329 2.0
FORESTRY
a. AGRICULTURE 1,093,074 1,226,200 12.2 570,322 582,064 2.1
Palay 301,314 362,501 20.3 143,852 147,921 2.8
Corn 78,379 87,725 11.9 40,067 42,162 5.2
Coconut including
77,110 98,709 28.0 29,429 27,987 -4.9
copra
Sugarcane 28,101 28,541 1.6 15,454 15,572 0.8
Banana 95,586 106,602 11.5 31,636 32,501 2.7

Principles of Economics, Taxation and Agrarian Reform 17


National Income Accounting

Mango 18,662 18,821 0.9 14,959 16,179 8.2


Pineapple 16,340 18,110 10.8 15,745 16,086 2.2
Coffee 5,350 5,529 3.3 2,914 2,791 -4.2
Cassava 18,221 16,802 -7.8 8,881 9,555 7.6
Rubber 16,568 10,766 -35.0 3,372 3,434 1.9
Other crops 66,307 69,719 5.1 41,280 41,666 0.9
Livestock 167,010 176,828 5.9 94,915 95,885 1.0
Poultry 118,133 129,131 9.3 77,682 77,930 0.3
Agricultural
85,994 96,416 12.1 50,137 52,396 4.5
activities & services
b. FORESTRY 4,756 4,797 0.9 5,261 5,265 0.1

2. FISHING 199,320 197,134 -1.1 131,003 130,495 -0.4

GROSS VALUE ADDED


IN AGRICULTURE,
1,297,151 1,428,131 10.1 706,586 717,824 1.6
HUNTING, FORESTRY
AND FISHING
Source: Philippine Statstics Authority
Posted: 27 August 2015

1.2 Methodology for Production Approach

Estimation Methodology at Current Prices Estimation Methodology


at Constant Price
Preliminary Revised
Direct Estimation: same as preliminary Direct Estimation:
GVA = Q x P x GVAR but uses updated data GVA = Q x P x GVAR
where P is the current price for where P is the base year price
the period

Principles of Economics, Taxation and Agrarian Reform 18


National Income Accounting

III. Limitations of GDP/GNP

As discussed, GDP is an important measure of the economic condition of a nation. But it has some
limitations, thus should not be considered the sole indicator of the country’s well-being. GDP does
not consider the following:

 Other social indicators like crime rate, illiteracy, life expectancy, infant mortality.
 Equity. A large GDP per capita does not mean that the wealth of a nation is shared equally.
In some nations, the GDP is distributed for the most part among a small elite class, leaving
the rest of the nation in poverty.
 Environmental issues. A high rate of production may have disastrous environmental
consequences.
 The underground economy. The GDP actually measured will fail to capture any goods and
services that are not reported to the government. This includes home-based workers, street
traders, street vendors, itinerants. The underground economy also include illegal activities,
like marijuana cultivation, shabu and cocaine sales, transactions in the black market and tax
evasion, all of which are not recorded.
 Household works for which people are not paid like the mothers who are doing the
household chores.

IV. The Philippine System of National Accounts

This topic is included for us to have a better understanding of how the government
determines or computes numbers and statistics that matters in our lives.

The System of National Accounts (SNA) provides a systematic statistical framework for
summarizing and analyzing the economic flows and wealth of an economy.

Purposes of SNA
• Assessment of economic performance;
• Gauging the impact of government policies and other factors (via supply and use and
input-output tables), including those from abroad;
• Formulation of economic targets in terms of ratios, such as tax revenue to GDP,
government deficit and debt to GDP, current account deficit/surplus to GDP; and,
• Identification of causal relationships between variables and the support of economic
models;
• Allows the user to focus on particular parts of the economy thru the data on institutional
sector and activity by industry

Basic Concepts

 The current PSNA basically follows the 1968 UN System National Account (SNA) but to a
limited scale incorporates the recommendations of the 1993 SNA.
 Transactors are economic units called institutional units. The institutional sectors in the
present PSNA are :
• Private Corporations

Principles of Economics, Taxation and Agrarian Reform 19


National Income Accounting

• Government Corporations
• General Government; and
• Households, including non-profit institutions serving households and unincorporated
enterprises.
 Economic territory does not coincide exactly with geographic territory
 Total economy consists of all institutional units that are residents of the country
 An institutional unit is said to be resident of a country when it has a center of economic
interest in the economic territory of country - that is when it engages for an extended period
(one year or more being taken as a practical guide) in economic activities of this territory

Salient Features of the 1993 SNA

 With more articulations introduced in the classifications and institutional sectoring,


compilers and users have more flexibility in prioritizing various parts of the accounts,
depending on the analysis required and data availability.
 Harmonized with other international statistical systems such as the Balance of Payment
(BOP), International Labour Organization (ILO), Government Finance Statistics (GFS), and
Money and Banking Statistics (MBS)
 More articulated accounts to address concerns such as the revaluation account that record
changes in prices or inflation
 Introduce the concept of Gross Domestic Income and the concept of Gross National Income
(GNI) to replace Gross National Product (GNP). GNI (at constant prices) is equal to GDP
(at constant prices) plus Trading Gains/Loss from changes in the terms of trade plus NFIA
(at constant prices)
 Introduce the concepts of mixed income and primary income
 Delineation of output into market output, output for own final use and non-market output.
 Provision of guidelines for the compilation of satellite accounts such as environmental,
tourism, education and transportation accounts.

Comparison of the 1993 SNA and the Current PSNA

1993 SNA CURRENT ANNUAL PSNA


Institutional Sectors Institutional Sectors
a. financial a. private corporations
b. non-financial b. government corporations
c. general government c. general government
d. households d. households including NPISHs and unincorporated
e. non-profit institution serving enterprises.
households.

Principles of Economics, Taxation and Agrarian Reform 20


National Income Accounting

Accumulation Account Only the capital account for the whole economy is covered. A
1. Capital Account matrix presentation of the financial account (Flow of Funds)
2. Financial Account is being compiled by the BSP.
3. Other Changes in Volume of Assets
Account
4. Revaluation

Mixed Income for unincorporated No distinction between operating surplus and mixed income
enterprises owned by households
- remuneration for work done by the
owner of the enterprise as well as a
return to entrepreneurship

Gross National Income (GNI) Uses GNP but GNI is found in the memo item on the main
table of the national accounts at constant prices

Military expenditures (except on Treated as current expenditure


weapons) are part of capital formation

Valuables which are held as stores of Treated as current expenditure


values are capital expenditures

Financial leasing is treated as capital To the extent that data can support, distinction between
formation while operational leasing is operational and financial leasing are considered.
treated as services

Principles of Economics, Taxation and Agrarian Reform 21


National Income Accounting

Special Data Dissemination Standard (SDDS) of the


International Monetary Fund (IMF)

Item IMF STANDARD PHILIPPINES


Coverage characteristics The SDDS does not prescribe GDP by expenditure and industry,
specific components of the GNP, current and constant 1985 prices,
national accounts; rather it implicit deflators, growth rates
prescribes either GDP by
productive sector (industry), or
expenditure shares or both.
Periodicity Quarterly Quarterly

Timeliness one quarter after the reference for Q1 to Q3 the time lag is two
period months while Q4 is one month after
the reference period.
Advance dissemination of Advance dissemination of release Schedule of releases of the National
release calendar dates that may be taken Accounts is published every January.

Principles of Economics, Taxation and Agrarian Reform 22


National Income Accounting

References:

Silon, E.T. (2012). Manual for Economics with Work Exercise.Rex Book Store

http://www.ask.com/world-view/national-income-accounting
http://www.economicsdiscussion.net/
http://www.investopedia.com/terms
http://www.investordictionary.com/
http://www.nscb.gov.ph/
http://www.peoi.org/Courses
http://philippinecapital.com/
https://www.psa.gov.ph/

Principles of Economics, Taxation and Agrarian Reform 23


Introduction
to
Taxation
Learning Objectives

Explain the importance of taxation in


the economy
Discuss the highlights of the country’s
tax administration
Differentiate the various types of
taxation
What is taxation
A means by which governments finance their
expenditure by imposing charges on their citizens
and corporate entities.

An involuntary fee levied on corporations or


individuals that is enforced by a level of
government in order to finance government
activities.
Importance of Taxation
Importance of Taxation
Revenue from taxation is the lifeblood of a nation
Taxation is one of the fund sources
Non-revenue objectives of Taxation
 Strengthen anemic enterprises or provide incentive to greater production
(tax exemptions, discounts, tax holiday)

 Protect local industries against foreign competition (Increasing import


taxes)

 As a bargaining tool during trade negotiations

 May be increased to curb spending power in time of prosperity to lower


inflation or decrease during recession and ward off depression

 May be levied to reduce inequalities of wealth and incomes ( estate, donor,


income)
Basic Principles of a Sound Tax System
1. Fiscal adequacy - it must be adequate to support the needs of
the government.

2. Administrative feasibility - must be capable of effective and


efficient enforcement.

3. Theoretical justice - in consonance with the constitutional


provisions that the rule of taxation must be equitable (burden
falls on those better able to pay), and uniform. Taxes must be
progressive (tax rate increases depending upon the resources of
the person affected
Essential Characteristics of Taxes
1. An enforced contribution
2. Generally payable in money
3. Proportionate in character
4. Levied on persons and property
5. Levied by the state, which has jurisdiction over the
person or property
6. Levied by the law-making body of the state
7. Levied for public purposes
Nature of Power of Taxation
 Inherent in sovereignty for the government to exist and to
function to serve its population

 Legislative in Character - only the Congress can impose


taxes.

 Not absolute and is subject to constitutional and inherent


limitations
Taxation System in the Philippines
The laws governing taxation in the Philippines are
contained within the National Internal Revenue Code.

This code underwent substantial revision with


passage of the Tax Reform Act of 1997.

 This law took effect on January 1, 1998.


REPUBLIC ACT NO. 8424
TAX REFORM ACT OF 1997
SECTION 2. State Policy. – It is hereby declared the
policy of the State to promote sustainable economic growth
through the rationalization of the Philippine internal
revenue tax system, including tax administration; to provide,
as much as possible,

a)an equitable relief to a greater number of taxpayers in


order to improve levels of disposable income and increase
economic activity;
b)to create a robust environment for business to enable
firms to compete better in the regional as well as the global
market,
c)at the same time that the State ensures that Government is
able to provide for the needs of those under its jurisdiction
and care.
Tax Administration
Through the Bureau of Internal Revenue
(BIR) which comes under the
Department of Finance (DOF)

The BIR Commissioner has the following


functions:
 exclusive and original jurisdiction to
interpret the provisions of the code and
other tax laws.
 has the powers to decide disputed
assessments, grant refunds of taxes, fees
and other charges and penalties,
 modify payment of any internal revenue
tax and abate or cancel a tax liability.

Taxpayers can appeal decisions by


the Commissioner directly to the
Court of Tax Appeals.
Primary tax incentives : Tax Holiday
 The Omnibus Investments Code grants to
enterprises that have registered with the
Board of Investments and that qualify
under the annual Investments Priority
Plan entitlements to tax holidays of either
four or six years ; and
.
 tax credits for purchase of Philippine-made
capital equipment and raw materials
Primary tax incentives :
Special Economic Zones
Special economic zones are areas where
export manufacturing firms are encouraged
to start operations. Under the Philippine
Export Zone Authority Law, a special
economic zone registered enterprise can, in
lieu of all other national and local taxes, pay a
tax of 5% of its gross income.
Primary tax incentives :
Special Economic Zones
A firm that has registered under the Omnibus
Investments Code that is located and
registered to do business within a special
economic zone can have a tax holiday for the
first four or six years of its operations,
followed by a 5% tax thereafter. The
exemption from national taxes covers all
internal revenue taxes, including the Value
Added Tax.
Primary types of taxation
A. Individual Income Tax
Residents engaged in trade or business are taxed upon
their net income (gross income less allowable
deductions and personal exemptions) according to a
schedule of rates ranging from 3% to 33%. The
maximum rate was reduced to 32% on January 1,
2000.

Residency tests are used to determine resident alien


status where the resident alien falls under the
Individual Income Tax schedule of rates.
Personal Exemptions
Single 50,000 pesos

Head of
family 50,000 pesos

Married
individuals 50,000 pesos

25,000 pesos
Minor each for the
dependents first 4
dependents
Passive Income
1. Interest
A ‘final’ tax of 20% is imposed on interest
income. This tax is withheld at the
source. Exceptions to this are:

i. Interest income from a depositary bank


with a Foreign Currency Deposit Unit is
subject to a final tax rate of 7.5%.

ii. Philippine long-term investments of over


five years are exempt from tax.
Passive Income
2. Dividends
A final tax of 10% is imposed on cash or
property dividends from domestic
corporations, joint stock companies,
insurance or mutual funds, or regional
operating headquarters of multinational
corporations.

The distributable net income, after tax, of a


partnership is subject to the same final tax as
dividends.
Passive Income
3. Capital gains

The tax code imposes a final tax of 5% on net


capital gains from the sale of stock in a
domestic corporation up to 100,000 pesos.

The tax is 10% for any income over 100,000


pesos.

 If the stock is stock exchange listed, a


transfer tax of 0.5% is also imposed.
Passive Income
4. Fringe benefits

Fringe benefits, such as housing, expense


accounts, vehicles, household personnel,
membership fees and educational fees are
taxable under the fringe benefits tax and are
payable by the employer, who is responsible for
withholding it and remitting it to the
government.
C. Corporation tax
•Resident foreign corporations engaged in trade
or businesses in the Philippines are taxed at the
same rates as domestic corporations.

•The corporation income tax rate is currently


30%.

•Effective January 1, 2000, the tax code includes


an option for corporations to be taxed at a rate
of 15% of gross income if the President of the
Philippines chooses to enact this option.
Classification and Types
1.As to subject matter or object
• Personal, poll, or capitation – tax of fixed amount imposed on a
persons residing within a specified territory without regard to
property, occupation or business (community /residence tax)

• Property tax – real or personal property, based on value or other


reasonable valuation (real estate tax)
1.As to subject matter or object

• C. Excise tax – any tax not classified as personal


or property tax. Tax imposed upon the
performance of an act, engaging in an
occupation, enjoyment of a privilege ( Income
tax, VAT, Estate tax, donor’s tax)
2. As to who bears the burden
• Direct – taxpayer is directly or primary liable or
which he cannot shift to another (Corporate and
individual income taxes, community tax, donor’s
tax, estate tax)

• Indirect - tax imposed upon goods before they


reach the consumer who ultimately pays for it not
as a tax but as part of the purchase price of good
sold or service rendered (VAT, percentage tax,
customs duties)
3. As to determination of amount

• Specific – tax of a fixed amount imposed by some standard of weight


or measurement, it requires no assessment or valuation (Taxes on
distilled spirits, wines, cigars, cigarettes)

• Ad Valorem – tax of fixed proportion of the value of the property,


“according to value ( real estate tax, customs duties)
4. As to purpose
• General, fiscal, or revenue – tax imposed for the
general purpose of the government to raise
revenue/funds ( VAT, income tax, real estate, etc)

• Special or regulatory – imposed for a special


purpose to achieve some socio-economic ends
irrespective whether revenue is actually raised or
not (Protective tariffs or customs duties)
5. As to scope or authority

• National – imposed by the national government (national internal


revenue taxes, customs duties)

• Municipal or local – imposed by municipal corporations or LGUs ( real


estate tax, professional tax)
6. As to graduation or rate
• Proportional or flat/uniform tax – the tax rate
remains constant for all levels of the tax base at
any given income level (real estate tax, VAT)

• Progressive or graduated – tax rate increases as


the tax base or bracket increases
• Regressive – the tax rate decreases as the tax base
or bracket increases
Tax Evasion and Tax Avoidance
• Tax Evasion – the use by the taxpayer of illegal means to reduce tax
payment. It is punishable by law.

• Tax Avoidance - use of taxpayer of legal means in order to avoid or


reduce tax liability. It is not punishable by law.
References
Ampongan, O. E. (2011). Income Taxation in the Philippines, Naga City :
ARTS CPA Review .

De Leon H.S.et.al.. (2012). The Fundamentals of Taxation. 16th Edition; Rex


Book Store
Liquigan,R. et.al. (2010), Basic Ecoomics with Agrarian Reform and
Taxation, Mega-Jesta Prints. Inc.
Stock W.A., (2013) Introduction to Economics: Social Issues and
Economic Thinking

Internet Web Sites:


http://www.answers.com/
www.bir.gov.ph
http://www.businessdictionary.com/ http://www.rocketswag.com/
www.dof.gov.ph
http://uspolitics.about.com/
http://economics.about.com/
http://www.investopedia.com/t /
http://www.philcorporation.com
/ph.images.search.yahoo.com
Introduction to Taxation and Agrarian Reform

10
Introduction to Taxation and Agrarian Reform
Government projects and programs are financed from taxes and other revenues collected from
citizens and businesses. According to the Department of Budget and Management (DBM),
around 94% of the targeted P2.3 trillion total revenues for 2015 will come from taxes. This
information is enough reason why we need to include taxation in our economic course.

On the other hand, agriculture is a crucial sector for reducing poverty and attaining the
Millennium Development Goals (MDG’s), which includes halving the proportion of people in
extreme poverty and hunger by 2015 (from its level in 1990). In 2012, some 12.1 million
workers or 32% of the 37.61 million employed Filipinos were in the agricultural sector.
However, NSCB studies show that concentration of the poor has been in the entire agriculture
sector with the farmer’s poverty incidence at 37%.

Objectives:

After studying this chapter, the students should be able to:

1. Explain the importance of taxation in the economy and differentiate the various types of
taxation;
2. Discuss the highlights of the country’s tax administration; and
3. Discuss the agrarian reform program and its status and accomplishment
4. Explain the role of cooperatives in the agrarian reform program

I. Introduction to Taxation

A. What is Taxation?

Taxation is the inherent power of the government, exercised through legislature, to


impose burdens upon the subjects and the objects, within its jurisdiction, for the purpose
of raising revenues to carry out the legitimate objects of the government.

Another definition defines taxation as a method of apportioning the cost of government


among those who are, in some measure, are privileged to enjoy the benefits, hence, a
share in the burden. Taxation is a means by which governments finance their expenditure
by imposing charges on their citizens and corporate entities

B. What is Tax?

Principles of Economics, Taxation and Agrarian Reform 1


Introduction to Taxation and Agrarian Reform

 Tax is an involuntary fee levied on corporations or individuals that is enforced by a


level of government in order to finance government activities.

 It is an enforced proportional contribution from persons and properties by the law


making body of the state by virtue of its sovereignty for the support of government
and all public needs.

C. Purpose and importance of taxation


The main purpose of taxation is to generate revenues for the government. This would
enable the government to perform its functions. No government could exist without the
necessary revenues. As had been mentioned, for 2015, some 94% of the government
revenue shall come from taxes.

In addition to this major function of taxation are the following non-revenue objectives of
taxation:
a. Strengthen anemic enterprises or provide incentive to greater production (tax
exemptions, discounts, tax holiday)
b. Protect local industries against foreign competition by increasing import taxes
c. As a bargaining tool during trade negotiations
d. May be increased to curb spending power in time of prosperity to lower inflation
or decrease during recession and ward off depression
e. May be levied to reduce inequalities of wealth and incomes (estate, donor, income)

D. Basic Principles of a Sound Tax System


a. Fiscal adequacy - it must be adequate to support the needs of the government or
sufficient to meet the demands for public expenditure.
b. Administrative feasibility - must be capable of effective and efficient
enforcement.
c. Theoretical justice - this is in consonance with the constitutional provisions that
the rule of taxation must be equitable (burden falls on those better able to pay),
and uniform. Taxes must be progressive wherein tax rate increases depending
upon the resources of the person affected based on the “ability to pay principle.”

E. Essential Characteristics of Taxes


a. An enforced contribution – a tax is not a voluntary payment or donation and its
imposition does not depend on the will of the person taxed

b. Generally payable in money – Unless qualified by law, the term tax is


understood to be a financial burden paid in money or the legal tender.

c. Proportionate in character – a tax is based on the ability to pay. It is laid by


some rule of apportionment according to which the person or property share the
public burden.

d. Levied on persons and property – A tax may also be imposed on acts,


transactions or contracts, but it is only a person who pays the tax.

Principles of Economics, Taxation and Agrarian Reform 2


Introduction to Taxation and Agrarian Reform

e. Levied by the state, which has jurisdiction over the person or property – this
is necessary so that the tax can be enforced. The taxing power of the state stops at
its boundary lines.

f. Levied by the law-making body of the state – the power to tax is a legislative
power which only the legislative body both in the national and local levels can
exercise through the enactment of statutes or ordinances. The power to tax is also
granted by the Constitution and by law to local government units subject to
limitations as maybe provided by law.

g. Levied for public purposes – taxation constitutes a charge or burden imposed to


provide income for public purposes like government support, the administration
of the law or the payment of public expenses.

F. Nature of Power of Taxation

a. Inherent in sovereignty for the government to exist and to function to serve its
population, hence, the state can still exercise its power to tax even if the
Constitution does not provide anything about taxation.

b. Legislative in Character - only the Congress can impose taxes as provided for in
the Constitution which also grants the LGUs the power to tax, subjected to
guidelines and limitations as may be provided by law.

c. It is subject to constitutional and inherent limitations – Most of these


limitations are provided in the fundamental law and it is not absolute.

G. Classification and Types of Taxes

1. As to subject matter or object


a. Personal, poll, or capitation – tax of fixed amount imposed on a person residing
within a specified territory without regard to property, occupation or business
(community/residence tax)
b. Property tax – real or personal property, based on value or other reasonable
valuation (real estate tax)
c. Excise tax – any tax not classified as personal or property tax. Tax imposed upon
the performance of an act, engaging in an occupation, enjoyment of a privilege
(income tax, VAT, Estate tax, donor’s tax)

2. As to who bears the burden


a. Direct – taxpayer is directly or primary liable; he cannot shift to another
(Corporate and individual income taxes, community tax, donor’s tax, estate tax)

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b. Indirect - tax imposed upon goods before they reach the consumer who ultimately
pays for it not as a tax but as part of the purchase price of the good sold or service
rendered (VAT, percentage tax, customs duties)

3. As to determination of amount
a. Specific – tax of a fixed amount imposed by some standard of weight or
measurement, it requires no assessment or valuation (Taxes on distilled spirits,
wines, cigars, cigarettes)
b. Ad Valorem – tax of fixed proportion of the value of the property, “according to
value (real estate tax, customs duties)”

4. As to purpose
a. General, fiscal, or revenue – tax imposed for the general purpose of the
government to raise revenue/funds (VAT, income tax, real estate)
b. Special or regulatory – imposed for a special purpose to achieve some socio-
economic ends irrespective whether revenue is actually raised or not (Protective
tariffs or customs duties)

5. As to scope or authority
a. National – imposed by the national government (national internal revenue taxes,
customs duties)
b. Municipal or local – imposed by municipal corporations or LGUs (real estate tax,
professional tax)

6. As to graduation or rate
a. Proportional or flat/uniform tax – the tax rate remains constant for all levels of the
tax base at any given income level (real estate tax, VAT)
b. Progressive or graduated – tax rate increases as the tax base or bracket increases
c. Regressive – the tax rate decreases as the tax base or bracket increases

H. Tax Evasion and Tax Avoidance

 Tax Evasion – the use by the taxpayer of illegal means to reduce tax payment. It is
punishable by law.

 Tax Avoidance - use of taxpayer of legal means in order to avoid or reduce tax liability.
It is not punishable by law.

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II. Taxation System in the Philippines


The laws governing taxation in the Philippines are contained within the National Internal
Revenue Code. This code underwent substantial revision with passage of the Tax
Reform Act of 1997. This law took effect on January 1, 1998.

Section 2. State Policy of R.A. NO. 8424 on the Tax Reform Act of 1997 provides that
it is hereby declared the policy of the State to promote sustainable economic growth
through the rationalization of the Philippine internal revenue tax system, including tax
administration; to provide, as much as possible:
a) an equitable relief to a greater number of taxpayers in order to improve levels
of disposable income and increase economic activity;
b) to create a robust environment for business to enable firms to compete better in
the regional as well as the global market,
c) at the same time that the State ensures that Government is able to provide for
the needs of those under its jurisdiction and care.

The tax administration is a undertaken through the Bureau of Internal Revenue (BIR)
which comes under the Department of Finance (DOF). The BIR Commissioner has the
following functions:

1. exclusive and original jurisdiction to interpret the provisions of the code and other
tax laws.
2. has the powers to decide disputed assessments, grant refunds of taxes, fees and
other charges and penalties,
3. modify payment of any internal revenue tax and abate or cancel a tax liability.

Taxpayers can appeal decisions by the Commissioner directly to the Court of Tax
Appeals.

Primary Tax Incentives


1. Tax Holiday
The Omnibus Investments Code grants to enterprises that have registered with the
Board of Investments and that qualify under the annual Investments Priority Plan
entitlements to tax holidays of either four or six years and tax credits for purchase of
Philippine-made capital equipment and raw materials

2. Special Economic Zones


Special economic zones are areas where export manufacturing firms are encouraged
to start operations. Under the Philippine Export Zone Authority Law, a special
economic zone registered enterprise can, in lieu of all other national and local taxes,
pay a tax of 5% of its gross income.

A firm that has registered under the Omnibus Investments Code that is located and
registered to do business within a special economic zone can have a tax holiday for
the first four or six years of its operations, followed by a 5% tax thereafter. The
exemption from national taxes covers all internal revenue taxes, including the Value
Added Tax.

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Primary types of taxation

1. Individual Income Tax


Residents engaged in trade or business are taxed upon their net income (gross income
less allowable deductions and personal exemptions) according to a schedule of rates
ranging from 3% to 33%. The maximum rate will be reduced to 32% on January 1,
2000. Residency tests are used to determine resident alien status where the resident
alien falls under the Individual Income Tax schedule of rates.

Personal Exemptions are granted based on the following table:


Classification Exemptions (in pesos)
Single 50,000.00
Head of the family 50,000.00
Married individuals 50,000.00
Minor dependents 25,000 pesos each for the first 4 dependents

2. Passive Income

a. Interest
A ‘final’ tax of 20% is imposed on interest income. This tax is withheld at the
source. Exceptions to this are:
i. Interest income from a depositary bank with a Foreign Currency Deposit
Unit is subject to a final tax rate of 7.5%.
ii. Philippine long term investments of over five years are exempt from tax.

b. Dividends
 A final tax of 10% is imposed on cash or property dividends from domestic
corporations, joint stock companies, insurance or mutual funds, or regional
operating headquarters of multinational corporations.
 The distributable net income, after tax, of a partnership is subject to the
same final tax as dividends.

c. Capital gains
 The tax code imposes a final tax of 5% on net capital gains from the sale
of stock in a domestic corporation up to 100,000 pesos.
 The tax is 10% for any income over 100,000 pesos.
 If the stock is stock exchange listed, a transfer tax of 0.5% is also imposed

d. Fringe benefits
Fringe benefits, such as housing, expense accounts, vehicles, household
personnel, membership fees and educational fees are taxable under the fringe
benefits tax and are payable by the employer, who is responsible for
withholding it and remitting it to the government.

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3. Corporation Tax

• Resident foreign corporations engaged in trade or business in the Philippines are


taxed at the same rates as domestic corporations.
• The corporation income tax rate is currently 30%.
• Effective January 1, 2000, the tax code includes an option for corporations to be
taxed at a rate of 15% of gross income if the President of the Philippines chooses
to enact this option.

II. Introduction to Agrarian Reform

A. Land reform and Agrarian Reform

Sec. 3(a) of R.A. No. 6657 or the Comprehensive Agrarian Reform Law (CARL) of 1988
defined agrarian reform as “the redistribution of lands, regardless of crops or fruits produced,
to farmers and regular farm workers who are landless, irrespective of tenurial arrangement, to
include the totality of factors and support services designed to lift the economic status of the
beneficiaries and all other arrangements alternative to the physical redistribution of lands,
such as production or profit sharing, labor administration, and the distribution of shares of
stock, which will allow beneficiaries to receive a just share of the fruits of the lands they
work.”

Agrarian reform encompasses land reform which is defined as an integrated set of measures
aimed to improve or remedy the defects in the relations between the tiller and the owner of
the land and employee and employer in a farm with respect to their rights in land. Land
reform involves agrarian structural reforms.

The agrarian structure is composed of the tenure structure, production structure, and the
structure of support services individually defined and discussed as follows:

1. Land tenure structure refers to one or more types of land tenure system regulating the
rights to ownership and control and usage and the duties accompanying said rights.
Possible land tenure reform measures are:
a. redistribution of private lands through expropriation or purchase;
b. distribution of lands in the public domain referred to as resettlement or colonization;
c. regulation of tenancy like penalties for wrongful eviction of tenants;
d. regulation of agricultural labor contracts and wages; and
e. elimination of absentee landlordism and transfer of land ownership to the actual
tillers.

2. Production structure relates to the nature, type, and actual process of production or farm
operation. This also concerns farm size, location, production unit or holdings like
individual tenant farms, family farms, cooperative or collective farms, corporate and
company farms.
The following are considered as production reform measures, among others:

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a. Consolidation of small uneconomic holdings to ensure optimum utilization;


b. Imposition of a floor on holdings of uneconomic size beyond which subdivision is
to be prevented;
c. Promotion of cooperative or compact farming among sub-marginal farmers
d. Imposition of a ceiling on holdings of non-cultivating owners; and
e. Organization of crop rotation system.

3. Support services structure involves matters like credit, marketing, supplying of


agricultural inputs like seeds and fertilizer, processing, storage, training and other
technical assistance relative to the land tenure and production structures. These reforms
spearheaded by the Department of Agrarian Reform, the Land Bank of the Philippines,
and the Bureau of Agricultural Extension of the Department of Agriculture, are designed
to ensure the success of the farmer who has acquired a new tenure status as lessee or
owner cultivator.

Agrarian reform is concerned not only with land reform but also the reform and
development of complementary institutional frameworks such as administrative agencies
of the national government, educational and social welfare institutions, cooperatives.
Agrarian reform does not limit itself to the question of relationships of farmers to land,
hence would cover the following areas:
a. Public health programs and family planning;
b. Application of labor laws to agricultural workers;
c. Reorganization of agrarian reform agencies;
d. Construction of infrastructure facilities such as feeder roads, farm to market road,
irrigation systems; storage facilities; processing plants; and
e. establishment of rural electrification

B. Aspects of Agrarian Reform


1. Economic aspect

Agriculture plays important role in the economic growth and development of the
country. Employing more than 12 million workers and contributing 11% to the
country’s Gross Domestic Product (GDP). Over the years, the agriculture sector’s
share in the GDP has been declining mainly because of the agricultural
productivity. Agricultural reforms must be implemented to empower farmers and
motivate them to produce more and better make them entrepreneurs marketing
their own produce. This would mean improvement in their standard of living,
providing them with the necessary income to purchase consumer and capital
goods.

2. Socio-cultural aspect
Based on Taiwan and Japan experience, the two countries which had been
successful in their agrarian reform programs, the following socio-cultural changes
were manifested:
a. The farmers were encouraged to produce more resulting to surplus;

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b. A social order in the farming villages was enhanced resulting to peace and
security in the community for them to sustain and enjoy the benefits;
c. Self confidence and leadership were developed and farmers began to
organize themselves and form cooperative and associations. They also
began to take active roles in the local and national elections; and
d. The agricultural productivity led to surpluses increasing the family income
which enabled farmers to send their children to school and acquire
consumer goods. Social contacts were improved and widened either from
their dealings in marketing their products or through the tri-media,
particularly the television.

3. Religious and moral aspects


There is a continuing clamor for the poor and landless farmers to own lands,
preferably, the land they had been tilling all their lives. Biblically and morally,
agricultural reforms should be implemented for the following reasons:
a. Peace and internal stability – our history would tell of the clashes between
the landlords and the tenants on the issue of land and many lives were lost
in the process.
b. Land-owners had already been compensated while the poor tenant who
had worked hard for the landlords are still wallowing in poverty.
According to the National Statistical Coordination Board (NSCB),
fishermen and farmers had the highest poverty incidence of 41% and 39%,
respectively. In addition to this, FAO study also found out that those who
are providing most of the nation's food, are also among the most food
insecure. According to the United Nations Food and Agricultural
Organization (FAO), food security encompasses: 1) physical availability
of food; 2) economic and physical access; 3) utilization; and 4) stability.
These four must be fulfilled simultaneously.
c. Innate tendency of man to own the land he tills since deep within himself,
he believes that this land must belong to him.
d. Issue of injustice involved in landlordism. Reformers are working for land
expropriation with minimum compensation to the landlords since the
tenants have more than paid from what the landlord has been getting from
every harvest.
e. Agrarian reform is the foundation for industrial progress. With farmers
owning the land and all the produce, there would be improvement and
increase in the farmers’ income enabling them to buy consumer and
capital goods of the industry.

4. Legal aspect
Agrarian reform legislations are labor laws not only for the purpose of regulating
tenant-landlord relationship but also directed to the higher goal of attainment of
larger social goals like industrialization, rural poverty alleviation and eliminate the
ills associated with land tenure.

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5. Political aspect
Agrarian reform is always a top priority agenda of the government. Presidential
Decree No. 2 was issued on September 26, 1972, within the first week of the
implementation of martial law declaring the country as a land reform area. Almost
a month later on October 21, 1972, PD No. 27 was issued mandating the
emancipation of the country’s rice and corn tenant farmers from their bondage by
transferring to them the ownership of the lands they till.

Under the new freedom Constitution of 1987, former President Corazon C. Aquino
signed Proclamation No. 131 and Executive Order 229 on July 22, 1987, putting
up the mechanism to start the implementation of the Comprehensive Agrarian
Reform Program (CARP).

Political will is a requirement for the continued implementation of agricultural


reforms to sustain whatever gains we had achieved.

C. The Comprehensive Agrarian Reform (CARP) in a Capsule


To better understand and be updated about CARP and its implementation, the
Presidential Communications Development and Strategic Planning Office and the
Department of Agrarian Reform came up with the following Q and A on CARP.

1. What is CARP? What is CARPER?


CARP stands for the Comprehensive Agrarian Reform Program, a government
initiative that aims to grant landless farmers and farm workers ownership of
agricultural lands. It was signed into law by President Corazon C. Aquino on June
10, 1988, and was scheduled to have been completed in 1998. On the year of its
deadline, Congress enacted a law (Republic Act No. 8532) appropriating
additional funds for the program and extending the automatic appropriation of ill-
gotten wealth recovered by the Presidential Commission on Good Governance
(PCGG) for CARP until 2008.

CARPER, or the Comprehensive Agrarian Reform Program Extension with


Reforms, is the amendatory law that extends yet again the deadline of distributing
agricultural lands to farmers for five years. It also amends other provisions stated
in CARP. CARPER was signed into law on August 7, 2009.

2. Who are the beneficiaries of CARP?


Landless farmers, including agricultural lessees, tenants, as well as regular,
seasonal and other farm workers. The Department of Agrarian Reform (DAR)
identifies and screens potential beneficiaries and validates their qualifications. For
example, to qualify, you must be at least 15 years old, be a resident of the barangay
where the land holding is located, and own no more than 3 hectares of agricultural
land.

3. What are the government offices involved in the program?

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Many agencies are involved in the implementation of CARP. The lead agencies are
the Department of Agrarian Reform (DAR), and the Department of Environment
and Natural Resources (DENR). They are in charge of the identification and
distribution of covered land, and is commonly referred to as CARPable land.

4. How much land is subject to land reform?


An estimated 7.8 million hectares of land is covered by CARP.

5. How much land has been acquired and distributed so far?


As of December 31, 2013, the government has acquired and distributed 6.9
million hectares of land, equivalent to 88% of the total land subject to CARP.

6. How much land was distributed to beneficiaries under this administration?


From July 2010 to December 2013, the administration has distributed a total of
751,514 hectares, or 45% of the total landholdings to be distributed to the farmer
beneficiaries left under this administration.

From this, DAR has distributed 412,782 hectares and DENR has already
distributed 338,732 hectares.

7. How much land does the government still need to acquire for distribution from
2014 to 2016?
DAR still needs to acquire 771,795 hectares, while the DENR still needs to
acquire 134,857 hectares—a total of 906,652 hectares.

8. How will the government acquire the landholdings?


There are different modes of acquiring and distributing public and private
agricultural lands. For private lands under compulsory acquisition, the DAR will
issue Notices of Coverage to the original owners of the landholdings. Notices of
Coverage will be issued to most of the landholdings by June 30, 2014.

9. What is a notice of coverage?


A Notice of Coverage (NOC) is a letter informing a landowner that his/her land is
covered by CARP, and is subject to acquisition and distribution to beneficiaries.
It likewise informs the landowner of his/her rights under the law, including the
right to retain 5 hectares.

10. After the period of time allotted for CARPER by law is passed (August 7, 2009
to June 30, 2014), how will the remaining landholdings, which are subject to
compulsory acquisition, be distributed to the beneficiaries?
As long as Notices of Coverage are issued on or before June 30, 2014, land
distribution to beneficiaries shall continue until completion, according to
Section 30 of CARPER (R.A. No. 9700).

Meaning, even after CARPER’s deadline, the law itself mandates the concerned
agencies to finish distributing lands to the beneficiaries up to the very last hectare.

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This assures to the farmers that the process for receiving their land will
continue (e.g., beneficiary identification, survey, generation, and registration of
land titles to beneficiaries).

11. How does DAR intend to deal with the remaining landholdings (771,795
hectares) to be distributed?
DAR projects that it will be distributing 187,686 hectares in 2014; 198,631
hectares in 2015; and 385,478 hectares in 2016.

Of the remaining CARPable landholdings to be distributed, 551,275 hectares are


considered workable, while 220,520 hectares are tagged as problematic. Solutions
for problematic landholdings will be worked out.

12. What were the challenges encountered in the course of acquiring and
distributing private lands?
There were numerous problems in implementing the land reform program:

a. In some cases, technical descriptions in the land titles (which determine the
boundaries of the land) were found to be erroneous and had to be corrected.
b. Some titles were destroyed, and therefore, had to be reissued by undergoing
a court process, similar to filing a case.
c. Potential beneficiaries argued among themselves on who should or should
not be qualified as beneficiaries; these disputes had to be mediated or
resolved by the government. In other cases, landowners may petition that
their lands be exempted or excluded from CARP coverage, and some of
these petitions have gone up to the Supreme Court.

Smaller parcels of land (5 hectares to 10 hectares) were only processed in the last
year of implementation of CARPER (July 1, 2013 to June 30, 2014). Past efforts
focused on bigger parcels of land, which involved more paperwork to process.
Now that efforts are focused on smaller but more numerous cuts of land, there are
more claim folders to process and distribute.

D. Agrarian Reform and Cooperative


Cooperatives play vital role in the implementation of the agrarian reform. Membership to
cooperative is a requisite to ownership of land by the tenant-farmers. The cooperative will
guarantee the payment of the annual amortizations to the landowners. The Cooperative
Development Authority (CDA) is the government agency tasked on matters concerning
cooperatives.

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What is Cooperative?
A cooperative is an autonomous and duly registered association of persons, with a
common bond of interest, who have voluntarily joined together to achieve their social,
economic and cultural needs and aspirations by making equitable contributions to
the capital required, patronizing their products and services and accepting a fair share
of risks and benefits of the undertaking in accordance with the universally accepted
cooperative principles.

What are the goals and objectives of cooperatives?

The primary objective of every cooperative is to help improve the quality of life of its
members. Towards this end, the cooperative shall aim to:

(a) Provide goods and services to its members to enable them to attain increased income,
savings, investments, productivity, and purchasing power, and promote among
themselves equitable distribution of net surplus through maximum utilization of
economies of scale, cost-sharing and risk-sharing;

(b) Provide optimum social and economic benefits to its members;

(c) Teach them efficient ways of doing things in a cooperative manner;

(d) Propagate cooperative practices and new ideas in business and management;

(e) Allow the lower income and less privileged groups to increase their ownership in the
wealth of the nation; and

(f) Cooperate with the government, other cooperatives and people-oriented organizations
to further the attainment of any of the foregoing objectives.

What are the types of cooperatives?


Cooperatives may fall under any of the following types:

(a) Credit Cooperative : is one that promotes and undertakes savings and lending
services among its members. It generates a common pool of funds in order to
provide financial assistance and other related financial services to its members
for productive and provident purposes;

(b) Consumer Cooperative : is one the primary purpose of which is to procure


and distribute commodities to members and non-members;

(c) Producers Cooperative : is one that undertakes joint production whether


agricultural or industrial. It is formed and operated by its members to undertake the
production and processing of raw materials or goods produced by its members into
finished or processed products for sale by the cooperative to its members and non-
members. Any end product or its derivative arising from the raw materials

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produced by its members, sold in the name of and for the account of the
cooperative, shall be deemed a product of the cooperative and its members;

(d) Marketing Cooperative : is one which engages in the supply of production


inputs to members and markets their products;

(e) Service Cooperative : is one which engages in medical and dental care,
hospitalization, transportation, insurance, housing, labor, electric light and power,
communication, professional and other services;

(f) Multi-Purpose Cooperative : combines two (2) or more of the business


activities of these different types of cooperatives;

(g) Advocacy Cooperative : is a primary cooperative which promotes and


advocates cooperativism among its members and the public through socially-
oriented projects, education and training, research and communication, and other
similar activities to reach out to its intended beneficiaries;

(h) Agrarian Reform Cooperative : is one organized by marginal farmers


majority of which are agrarian reform beneficiaries for the purpose of developing
an appropriate system of land tenure, land development, land consolidation or land
management in areas covered by agrarian reform;

(i) Cooperative Bank : is one organized for the primary purpose of providing a
wide range of financial services to cooperatives and their members;

(J) Dairy Cooperative : is one whose members are engaged in the production of
fresh milk which may be processed and/or marketed as dairy products;

(k) Education Cooperative : is one organized for the primary purpose of owning
and operating licensed educational institutions, notwithstanding the provisions of
Republic Act No.9155, otherwise known as the Governance of Basic Education
Act of 2001;

(l) Electric Cooperative : is one organized for the primary purpose of undertaking
power generation, utilizing renewable sources, including hybrid systems,
acquisition and operation of sub transmission or distribution to its household
members;

(m) Financial Service Cooperative : is one organized for the primary purpose of
engaging in savings and credit services and other financial services;

(n) Fishermen Cooperative : is one organized by marginalized fishermen in


localities whose products are marketed either as fresh or processed products;

(o) Health Services Cooperative : is one organized for the primary purpose of
providing medical, dental, and other health services;

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(p) Housing Cooperative : is one organized to assist or provide access to housing


for the benefit of its regular members who actively participate in the savings
program for housing. It is co-owned and controlled by its members;

(q) Insurance Cooperative : is one engaged in the business of insuring life and
property of cooperatives and their members;

(r) Transport Cooperative : is one which includes land and sea transportation,
limited to small vessels, as defined or classified under the Philippine maritime
laws, organized under the provisions of RA 9520;

(s) Water Service Cooperative : is one organized to own, operate and manage
waters systems for the provision and distribution of potable water for its members
and their households;

(t) Workers Cooperative : is one organized by workers, including the self-


employed, who are at the same time the members and owners of the enterprise. Its
principal purpose is to provide employment and business opportunities to its
members and manage it in accordance with cooperative principles; and

(u) Other types of Cooperatives : as may be determined by the Authority.

What are the categories of cooperatives?


Cooperative shall be categorized according to membership and territorial consideration.
In terms of membership, cooperatives shall be categorized into:

Primary-the members of which are natural persons.


Secondary-the members of which are primaries.
Tertiary-the members of which are secondary cooperatives.

Thus, those with cooperative memberships are considered federations or unions as the
case may be. In terms of territory, cooperatives shall be categorized according to areas of
operation which may or may not coincide with the political subdivisions of the country.
Those organized by minors shall be considered a laboratory cooperative and must be
affiliated with a registered cooperative. It is governed by special guidelines promulgated
by the CDA.

Who can be Members of a Cooperative?


A cooperative has two kinds of members: regular members and associate members.

A regular member is one who has complied with all the membership requirements and entitled
to all the rights and privileges of membership as stated in the Cooperative Code and the
cooperative by laws.

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An associate member has no right to vote and be voted upon and is entitled only to such rights
and privileges provided by the cooperative's by laws.

What are the privileges of a cooperative?


Cooperative registered under R.A. 9520 can enjoy the following privileges:

(1) Cooperatives shall enjoy the privilege of depositing their sealed cash boxes or containers,
documents or any valuable papers in the safes of the municipal or city treasurers and other
government offices free of charge, and the custodian of such articles shall issue a receipt
acknowledging the articles received duly witnessed by another person;

(2) Cooperatives organized among government employees, notwithstanding any law or


regulation to the contrary, shall enjoy the free use of any available space in their agency, whether
owned or rented by the Government;

(3) Cooperatives rendering special types of services and facilities such as cold storage, ice plant,
electricity, transportation, and similar services and facilities shall secure a franchise therefor, and
such cooperatives shall open their membership to all persons qualified in their areas of
operation;

(4) In areas where appropriate cooperatives exist the preferential right to supply government
institutions and agencies rice, corn and other grains, fish and other marine products meat, eggs,
milk, vegetables, tobacco and other agricultural commodities produced by their members shall be
granted to the cooperatives concerned;

(5) Preferential treatment in the allocation of fertilizers and in rice distribution shall be granted to
cooperatives by the appropriate government agencies;

(6) Preferential and equitable treatment in the allocation or control of bottomries of commercial
shipping vessels in connection with the shipment of goods and products of cooperatives;

(7) Cooperatives and their federations, such as market vendor cooperatives, shall have
preferential rights in management of public markets and/or lease of public market facilities, stall
or spaces;

(8) Credit cooperatives and/or federations shall be entitled to loans, credit lines, rediscounting of
their loan notes, and other eligible papers with the Development Bank of the Philippines, the
Philippine National Bank, the Land Bank of the Philippines and other financial institutions
except the Central Bank of the Philippines;

(9) Cooperatives transacting business with the Government of the Philippines or any of its
political subdivisions or any of its agencies or instrumentalities, including government-owned
and controlled corporations shall be exempt from pre-qualification bidding requirements; and

(10) Cooperatives shall enjoy the privilege of being represented by the provincial or city fiscal or
the Office of the Solicitor General, free of charge, except when the adverse party is the Republic

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Introduction to Taxation and Agrarian Reform

of the Philippines.

(11) Cooperatives shall enjoy the privilege of being represented by the provincial or city fiscal or
the Office of the Solicitor General, free of charge, except when the adverse party is the Republic
of the Philippines;

(12) shall have the preferential right in the management of the canteen and other services related
to the operation of the educational institution where they are employed: Cooperatives organized
by faculty members and employees of educational institutions Provided, That such services are
operated within the premises of the said educational institution; and

(13) The appropriate housing agencies and government financial institutions shall create a
special window for financing housing projects undertaken by cooperatives, with interest rates
and terms equal to, or better than those given for socialized housing projects. This financing shall
be in the form of blanket loans to qualified cooperatives, without need for individual processing.

How to organize a Cooperative?


Organizing a cooperative can be complex and simple. It requires an understanding of the basic
needs of the prospective cooperative members. It demands patience from the organizer who must
make the cooperative's long-term goals and objectives, and its visions a real part of the members'
lives.

But it can be too easy because the Cooperative Code of the Philippines (RA 6938) has devised
very clear-cut steps for the cooperative organizer and members. The following are the basic
information that the prospective members should understand before organizing a cooperative.

There are nine (9) steps suggested in setting up a cooperative.

FIRST. Get organized. You must have at least 15 members to do that. At once determine the
common problems you would want solved and the basic needs you would want provided for
through a cooperative. You may want to include increasing your production, marketing your
produce, credit assistance, power generation, banking or insurance and other similar needs.
Determining your problems and needs will also help you classify the kind of cooperative you
will be organizing. Even before a cooperative is set up, a dedicated core group people who will
do all the organizational and paper works is a must. From this core group, working communities
may be formed to set things moving. These committees may include membership, finance,
executive, secretariat to name a few.

SECOND. Reserve your proposed cooperative name. Secure and fill up Cooperative Name
Reservation Request Form (CNRRF). This must be submitted to CDA Central Office or any of
its Extension Office. A reservation fee shall apply.

THIRD. Prepare a general statement called an economic survey. Economic Survey is a general
statement describing, among others, the structure and purposes of the proposed cooperative. The
structure and actual staffing pattern shall include a bookkeeper. This should indicate the area of
operation, the size of membership and other pertinent data in a format provided by the

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Authority.

FOURTH. Prepare the cooperative's by-laws. The by-laws contain the rules and regulations
governing the operation of the cooperative.

FIFTH. Prepare the articles of cooperation. Mandatory contents of the articles of cooperation are
the following:

(a) the name of the cooperative, which must include the word "cooperative";
(b) the purpose or purposes and scope of business for which the cooperative is to be registered;
(c) the term of existence of cooperative;
(d) the area of operation and the postal address of its principal office;
(e) the names, nationality and the postal addresses of the registrants;
(f) the common bond of membership;
(g) The list of names of the directors who shall manage the cooperative; and

(h) The amount of its share capital, the names and residences of its contributors, and a statement
of whether the cooperative is primary, secondary or tertiary. The articles of cooperation shall be
signed by each of the organizers and acknowledged by them if natural persons, and by the
chairpersons or secretaries, if juridical persons, before a notary public. .

SIXTH. Secure bond of accountable officer(s). A surety bond should be secured from a duly
registered insurance or bonding company. Every director, officer and employee handling funds,
securities or property on behalf of the cooperative shall be covered by this. The board of
directors shall determine the adequacy of such bonds.

SEVENTH. Execute Treasurers Affidavit. A sworn statement of the treasurer elected by the
subscribers showing that at least twenty-five per centum (25%) of the authorized share capital
has been subscribed, and at least twenty-five per centum (25%) of the total subscription has been
paid should be executed and to be attached to the articles of cooperation. The paid-up share
capital shall not be less than Fifteen thousand pesos (P15,000.00)..

EIGHTH. Complete the Pre-Membership Education Seminar (PMES). A prospective member of


a primary cooperative must have completed a Pre-Membership Education Seminar (PMES). A
Certificate of PMES must be secured from the training provider.

NINTH. Register your cooperative with the Cooperative Development Authority (CDA)..
Submit the following required documents in four (4) copies:

Four (4) copies each of the Economic Survey, Articles of Cooperation and By-Laws duly
notarized;
1. Economic Survey;
2. Articles of Cooperation and By-Laws;
3. Surety bond of acountable officers;
4. Treasurer's Affidavit;
5. Approved Cooperative Name Reservation Slip;
6. Certificate of PMES;

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Introduction to Taxation and Agrarian Reform

Where do we register cooperative?


The Cooperative Development Authority (CDA) is the sole government agency mandated to
register all types of cooperatives subject to corresponding registration fees. Its main office is
located at 827 Aurora Blvd., Immaculate Conception, Quezon City.

Prospective cooperatives must submit their application to the CDA Extension Office where the
principal office of the cooperative is located.

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Introduction to Taxation and Agrarian Reform

Latest Statistics on Cooperatives


DAR, Philippines

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Introduction to Taxation and Agrarian Reform

Principles of Economics, Taxation and Agrarian Reform 21


Introduction to Taxation and Agrarian Reform

Principles of Economics, Taxation and Agrarian Reform 22


Introduction to Taxation and Agrarian Reform

References:

De Leon, H.S., (2012). Textbook on Agrarian Reform and Taxation with Cooperative.
14th Edition.Rex Book Store

Liquigan, R.L., et.al (2010). Basic Economics with Agrarian Reform and Taxation,
Mutya Publishing House, Inc.

http://www.cda.gov.ph/
http://www.dar.gov.ph/q-and-a-on-carp/english
http://www.nscb.gov.ph/beyondthenumbers/2013/04122013_jrga_agri.asp#tab1
http://www.rappler.com/move-ph/issues/hunger/52372-agriculture-hunger-food-security

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