ECONOMICS

The Fundamentals of Economics

By
Prof. Michael Angelo P. Battung
 ECONOMICS

Comes from the Ancient Greek Word “oikos” means

house and “nomos” means custom or law
ECONOMICS

It is the study of the use of scarce resources

to satisfy unlimited human wants and needs.
It deals on scarcity of resources on how a
producer makes a best quality product with the
use of limited raw materials.
ECONOMICS

Need – Is something that you have to have.

Want – Is something you would like to
have.
Scarcity
Exists when there is not enough of
something (product / service / resource) to
satisfy everyone’s needs and wants at a
ZERO PRICE.
ECONOMICS AS A SOCIAL SCIENCE

Positive Statements – Concern on what it is,

was or will be. It is the assertions, statements,
or theories may be simple or complex, but
basically about matters of fact.
Normative Statements – Concern what one
believes ought to be
ECONOMICS AS A SOCIAL SCIENCE

The well known tool use to determine the

exact prediction is by the use of surveys
and other statistical techniques.
ECONOMICS AS A SOCIAL SCIENCE

Variable – is a magnitude that can take on

different possible values.
Important Roles of Economics:
1. Analyzes how a society's institutions and technology affect prices
and the allocation of resources among different uses.
2. Explores the behavior of the financial markets, including interest
rates and stock prices.
3. Examines the distribution of income and suggests ways that the
poor can be helped without harming the performance of the
economy.
4. Studies the business cycle and examines how monetary policy can
be used to moderate the swings in unemployment and inflation.
5. Studies the patterns of trade among nations and analyzes the
impact of trade barriers.
6. Asks how government policies can be used to pursue important
goals such as rapid economic growth, efficient use of resources, full
employment, price stability, and fair distribution of income.
Inputs and Outputs

Inputs – are commodities or services that are used to produce

goods and services.
Outputs – are the various useful goods or services that result
from the production process.
Resources and Commodities

A society’s resources consist of natural gifts like land, forests,

and minerals, both mental and physical; and manufactured aids
to production such as tools, machinery and buildings.
Economists called it Factors of Production.

Commodity – The things produced from raw materials of

nature to sustain human wants.
FACTORS OF PRODUCTION

LAND

LABOR

CAPITAL
Two Branches of Economics

Micro Economics – The branch of Economics

concerned with the behaviour of individual
entities such as markets, firms, and households.
Adam Smith
- Father of Classical Economics
- In 1776 he created the book entitled “The Inquiry in
the Nature and the Causes of the Wealth of Nations”.
- He emphasized the law of “laissez-faire” meaning it is
the natural process of the economy and should not
intervene the government to prevent equilibrium.
- He also created the law of invincible hand. The
government will not intervene to commodity prices.
Two Branches of Economics

Macro-Economics – Concerned with the

overall performance of the economy.
John Maynard Keynes

- The government should spend money on

public works, infrastructures, and economic
programs to increased the resurgence of
business activity, and the restoration of full
employment.
Three Problems of Economic Organization

1. What to produce?
2. How to produce?
3. For whom to produce?
Economy
- A set of interrelated production and consumption activities.
Three types of economy:
1. Free – Market Economy – An economy in which the decisions of
individual households and firms exert the major influence over the
allocation of resources.
2. Command Economy – The major decisions about the allocation of
resources are made by the government and in which firms and
households produce and consume only as they are ordered.
3. Mixed – Economy – Combination of Command and Market Economy.
Classic Theories
of Economic
Growth and
Development
 INTRODUCTION

EVERY NATION
STRIVES FOR DEVELOPMENT
But economic progress is not the only component

DEVELOPMENT > material & financial

Widespread realization = national context +
international economic + social system
 FOUR APPROACHES

Post World War II

1. Linear stages of growth
2. Theories and patterns of structural change
3. International-dependence revolution
4. Neo-classical, free market
counterrevolution
 POST WORLD WAR II

Context:
- Struggle to rebuild
- Postwar economic boom
- Demand for consumer
goods
- Flowing foreign aid to countries like PH
- PH context: Bell Trade Act (no import duties for
US products)
I. LINEAR STAGES
THEORY
 I. LINEAR STAGES THEORY

DEVELOPMENT AS GROWTH
Post-war interest on poor nations
- Economists had no conceptual apparatus for largely
agrarian countries w/o modern economic structures
Strands of thought
- Marshall Plan: US financial and technical
assistance to war-torn European countries
- All modern industrial nations were once
underdeveloped agrarian societies
 I. LINEAR STAGES THEORY

Rostow’s
Stages of
Growth

* Developed countries already passed all stages. Underdeveloped in

traditional and preconditions stage should just follow rules of dev’t to
self-sustaining economy
 I. LINEAR STAGES THEORY

The Harrod-Domar Growth Model

• the rate of growth of GDP ( Y/Y) is determined jointly
by the net national savings ratio, s, and the national
capital-output ratio, c.
* To grow, economies must save and invest
* Other components: labor force growth & technological progress
• Sample:

• Countries able to save 15% to 20% would develop faster

• PROBLEM: relatively low level of new capital formation in most poor
countries ANSWER: through either foreign aid or private foreign
investment (justified Marshall plan for developing world)
 I. LINEAR STAGES THEORY

PROBLEMS:
• Mechanisms of development embodied in the
theory DOES NOT ALWAYS WORK
• WHY? More savings and investment are not
sufficient
• Worked for Europe because of necessary
structural, institutional, and attitudinal conditions
 II. STRUCTURAL
CHANGE MODELS
 II. STRUCTURAL CHANGE

2-SECTOR SURPLUS MODEL/

LEWIS THEORY OF DEVELOPMENT
- Structural transformation of a subsistence economy
• Presence of 2 sectors: overpopulated rural sector w/
zero marginal labor productivity and a high-productivity
industrial sector
• Transfer of labor from traditional to modern, growth of
product output
 II. STRUCTURAL CHANGE

LEWIS THEORY OF DEVELOPMENT

- Growth until surplus labor is absorbed by industrial sector
- Lewis turning point: declining labor-to-land ratio
(marginal product of rural labor no longer 0) = labor
supply curve positively sloped as modern-sector wage &
employment grow
 II. STRUCTURAL CHANGE

LEWIS THEORY OF DEVELOPMENT

CRITICISMS:
1. Assumes labor transfer & employment creation proportional
to capital accumulation. But what if profits invested in labor-
saving equipment?
2. Contemporary research show little surplus labor in rural areas
(except in some countries like China)
3. Urban surplus labor
4. Wages increase amid unemployment
 II. STRUCTURAL CHANGE

PATTERNS OF DEVELOPMENT ANALYSIS

- Economic, industrial and institutional structure of an economy
transformed to permit new industries as engine of growth
- Capital accumulation + changes in economic structure needed
- Constraints (affect level of dev’t): Internal - resources,
population size, government policies; External – access to
capital, technology, trade (countries as part of internatl system)
- Empirical work of Harvard economist Holllis Chenery and his
colleagues, cross-sectional and time-series studies of
countries at diff. levels of per capital income, identified
characteristic features of the development process:
 II. STRUCTURAL CHANGE

PATTERNS OF DEVELOPMENT ANALYSIS

• Shift from agri to industrial production
• Steady accumulation of physical and human capital
• Change in consumer demand from basic necessities to diverse
manufactured goods
• Growth of cities and urban industries
• Decline in family size ad overall population

- Proponents of structural change model prefer “facts to speak for

themselves” unlike theories such as stages of growth
 II. STRUCTURAL CHANGE

CONCLUSIONS
• Major hypothesis: development is an identifiable process of
growth and change with features similar in all countries.
• Problem: The model does not recognize differences, factors
influencing development process.
• Limitations of emphasizing patterns over theory. May draw
wrong conclusions about causality.
• Optimistic that “correct” mix of policies will generate beneficial
patterns
III. INTERNATIONAL-
DEPENDENCE
REVOLUTION
 III. INTERNATIONAL-DEPENDENCE
REVOLUTION

1970s – International-dependence models

gained support because of disenchantment
w/ stages and structural-change models
• Resurgence in various forms in the 21st century

Developing countries caught in a dependence and

dominance relationship with rich countries because
of institutional, political and economic rigidities =
difficulty for poor nations to be self-reliant and
independent
 III. INTERNATIONAL-DEPENDENCE
REVOLUTION

1. NEOCOLONIAL DEPENDENCE MODEL

- Indirect outgrowth of Marxist thinking
- Underdevelopment as result of historical evolution of highly
unequal international capitalist system of rich country-poor
country relationships
- Regardless if intentional, nations are under unequal power
relations between the center and the periphery
 III. INTERNATIONAL-DEPENDENCE
REVOLUTION

1. NEOCOLONIAL DEPENDENCE MODEL

- Small elite ruling class (landlords, entreps, military rulers,
merchants, public officials, etc.) interests (knowingly or not) to
perpetuate the international capitalist system of inequality
- The elite serve or are rewarded by international special-
interest power groups tied by allegiance or funding to wealthy
capitalist countries
- Elites’ viewpoints inhibit genuine reform efforts and may lead
to even lower levels of living and perpetuation of
underdvelopment
- External-induced against internal constraints
 III. INTERNATIONAL-DEPENDENCE
REVOLUTION

1. NEOCOLONIAL DEPENDENCE MODEL

- Revolutionary struggles or major restructuring of world
capitalist system required to free dependent nations
- Theotonio Dos Santos: Dependence as conditioning situation
; Expand based on expansion of dominant countries; Dominant
countries w/ technological, commercial, capital and
sociopolitical predominance can exploit and extract local
surplus; Dependence as based on the international division of
labor – industrial development in some and restricted in others
 III. INTERNATIONAL-DEPENDENCE
REVOLUTION

1. NEOCOLONIAL DEPENDENCE MODEL

• Pope John Paul II: One must denounce the existence of
economic, financial, and social mechanisms which,
although they are manipulated by people, often function
almost automatically, thus accentuating the situation of
wealth for some and poverty for the rest. These
mechanisms, which are maneuvered directly or indirectly
by the more developed countries, by their very
functioning, favor the interests of the people manipulating
them. But in the end they suffocate or condition the
economies of the less developed countries.
 III. INTERNATIONAL-DEPENDENCE
REVOLUTION

2. FALSE-PARADIGM MODEL
- less-radical
- Underdevelopment as result of faulty and inappropriate
advice by well-meaning, though uninformed or biased
advisers from developed country agencies and orgs
- Inappropriate policies merely serving vested interests of
existing power groups (domestic and international)
- Intellectuals, economists, civil servants trained in alien and
“irrelevant” Western concepts
 III. INTERNATIONAL-DEPENDENCE
REVOLUTION

3. DUALISTIC-DEVELOPMENT THESIS
Dualism – divergence between rich and poor nations,
rich and poor peoples on various levels
 III. INTERNATIONAL-DEPENDENCE
REVOLUTION

4 KEY ARGUMENTS
- Different sets of conditions coexist: rich and poor, modern
and traditional (Lewis model), elites and masses, powerful
industrialized nations and impoverished peasant societies
- Chronic coexistence (not temporary) of wealth and poverty
will not be rectified in time.
- Degrees of superiority or inferiority show no signs of
diminishing and instead increases
- Superior element does little to pull up or “trickle down” to the
inferior element, may even push it down
 III. INTERNATIONAL-DEPENDENCE
REVOLUTION

- IDR models, amid ideological differences, all reject the

emphasis on traditional neoclassical economic theories
- Question validity of the Lewis-type models, reject Chenery
observation of “well-defined empirical patterns” that should
be followed by poor countries
- Emphasis on international power imbalances and need for
economic, political and institutional reforms (internal &
world)
- Expropriation of private assets w/ expectation that public
asset ownership and control will help address poverty &
unemployment
 III. INTERNATIONAL-DEPENDENCE
REVOLUTION

WEAKNESSES:
- Appealing explanation but no insight on how countries
initiate and sustain development
- Actual economic experience of developing countries that
pursued revolutionary campaigns of industrial
nationalization and state-run production has been mostly
negative

* Based on dependency theory, countries could pursue a policy

of autarky or inwardly directed development & trade w/
other developing countries
 IV. NEOCLASSICAL
COUNTERREVOLUTION
 IV. NEOCLASSICAL
COUNTERREVOLUTION

Neoclassical counterrrevolution
- Challenges statist models in favor of free markets, public
choice & market-friendly approaches
- Developed nations: favored supply-side macroeconomic
policies, rational expectations theories and privatization of
public corporations
- Developing countries: freer markets and dismantling of
public ownership, statist planning and government
regulation
 IV. NEOCLASSICAL
COUNTERREVOLUTION

Context
- Emerged in the 1980s during political ascendancy of
conservative governments of US, Canada, Britain and West
Germany
- Neoclassicists on the board of powerful international
agencies World Bank and International Monetary Fund as
influence of International Labor Organization, United
Nations Development Program and United Nations
Conference on Trade and Development eroded
 IV. NEOCLASSICAL
COUNTERREVOLUTION

Argument
- Underdevelopment resulted from poor resource allocation
because of incorrect pricing policies and state intervention
(corruption, inefficiency, lack of incentives, etc.)
- State intervention slows economic growth
- Neoliberals: economic efficiency and growth will be
stimulated by free markets, privatizing state enterprises,
export expansion and eliminating government regulation
and price distortions
- Allow “magic of the marketplace” and “invisible hand” to
guide resource allocation and stimulate economic dev’t
 IV. NEOCLASSICAL
COUNTERREVOLUTION

3 component approaches
1. Free-market approach - markets alone are efficient;
competition is effective, technology and information
freely available and costless; gov’t is counterproductive
2. Public choice approach - new political economy
approach; governments do nothing right because of
selfish interests; misallocation of resources
3. Market-friendly approach – imperfections in economy
and need gov’t for market-friendly interventions (social
services and climate for private enterprise);
acceptance of market failures
 IV. NEOCLASSICAL
COUNTERREVOLUTION

Traditional Neoclassical Growth Theory

Liberalization – opening up of markets, draw investment
and increase rate of capital accumulation
Solow neoclassical growth model - economies to
converge to same income level if same rates of
savings, depreciation, labor force and productivity
growth.
Source of output growth: labor quantity and quality,
increase in capital and technology improvement
Openness – encourages access to foreign production
ideas, technological progress
 IV. NEOCLASSICAL
COUNTERREVOLUTION

CONCLUSIONS
• Finger-pointing between dependence theorists (many
from developing countries, seeing underdevelopment
as externally induced phenomenon) and neoclassical
revisionists (most from Western economies, blame
gov’t intervention and bad economic policies)
• Market price allocation may do a better job than state
intervention but developing economies have very
different structures:
• Competitive free markets generally do not exist, information is
limited, markets fragmented, etc.
 IV. NEOCLASSICAL
COUNTERREVOLUTION

CONCLUSIONS
• Invisible hand often lifts those already well-off, failing to
offer opportunities for upward mobility of the majority
• Lessons from supply-and-demand analysis to arrive at
“correct” prices
• “In an environment of widespread institutional rigidity
and severe socioeconomic inequality, both markets and
governments will typically fail.”
RECONCILING
DIFFERENCES
 RECONCILING DIFFERENCES

• Each approach has strengths and weaknesses

• Controversies – ideological, theoretical or empirical –
makes the study of economic development challenging
• Evolving patterns of insights and understandings
• CONSENSUS? Significance from each approach:
- Linear stages: crucial role of savings and investment
- Two-sector model: transfer of resources from low to high-
productivity activities, linkages between traditional & modern
- Dependence theory: importance of world economy and
decisions of developed world affecting developing economies
- Neoclassical: efficient production, proper price systems
MEASURING NATIONAL
OUTPUT AND NATIONAL
INCOME
GROSS DOMESTIC PRODUCT (GDP) versus
GROSS NATIONAL PRODUCT (GNP)

1.GDP
It is the market value for all final goods
and services produced within a given
period of time by factors of production
located within the country.

a. GDP is concerned only with new and current

production .
b. GDP also excludes output produced abroad
by domestically owned factors of production.
c. Intermediate goods (those goods that are
produced by one firm for use in further processing
by another firm) are not counted in the GDP.
2. GNP
Is the total market value of all final
goods and services produced within a
given period by factors of production
owned by a country’s citizens
regardless of where the output is
produced.
 CALCULATING GROSS DOMESTIC
PRODUCT (GDP)
1.EXPENDITURE APPROACH
GDP = C + I + G + (EX – IM)
where:
C = Personal Consumption expenditures – household
spending on consumer goods
I = Gross Domestic Investment – spending by firms and
households on new capital, plant, equipment, inventory
and new residential structures
G = government consumption and investment
EX – IM = net exports – net spending by rest of the world
or exports minus imports
 C = PERSONAL CONSUMER
EXPENDITURES CATEGORIES

1. Durable goods – goods that last a

relatively long time such as cars and
household appliances
2. Nondurable goods – goods that are
used up fairly quickly such as food and
clothing
3. Services – things we buy that do not
involve the production of physical things
such as legal and medical services and
education
 I = GROSS PRIVATE DOMESTIC
INVESTMENT
TYPES OF INVESTMENT

1. Gross Private Investment – total investment in

capital, it is the purchase of new housing,
equipment and plants by private sector
2. Nonresidential Investment – expenditures by
firms for machines, tools, plants and so on
3. Residential Investment – expenditures by firms
and on new houses and buildings
4. Change in Business Inventories – amount by
which firms inventories change during a period,
inventories are goods that firms produce now but
intend to sell later
GOVERNMENT CONSUMPTION AND
INVESTMENT refers to federal, state and
local governments for final goods and
services.

NET EXPORTS (EX – IM) is the difference

between exports and imports, figure can
be negative or positive
 A. NATIONAL INCOME
Is the total income earned by the factors of production
owned by country’s citizen

a. Compensation of employees – includes wages,

salaries and various supplements
b. Proprietor’s income – income of unincorporated
businesses
c. Corporate profits – income of corporate businesses
d. Net interest – interest paid by business
e. Rental income – income received by property
owners in from of rent
 PER CAPITA GDP/GNP
A country’s GDP or GNP divided by its population.

It is a better measure of well-being for the average

person than total GDP or GNP.

NOTES: Switzerland has the highest per capita GNP

of $40,630, followed by Japan $39,640 and Norway
$31,250.

Philippines has a per capita GDP/GNP of $1,050.

Mozambique has a per capita GDP/GNP of $80.
 LIMITATIONS OF THE GDP
CONCEPT
1.GDP is not always reflective of increases in
social welfare

Example:
a. Decrease in crime rate – not considered
as increase in output and is not reflected in
GDP
b. Increase in leisure – may be associated
with decrease in GDP (less time is spent on
producing output)
2. GDP seldom reflects losses or social ills.
GDP accounting rules DO NOT ADJUST for
production that POLLUTES the environment.

Thus:
THE MORE PRODUCTION there is, the
LARGER the GDP, regardless of how much
pollution results in the process.
3. GDP does not measure the effects of
redistributive policies
It does not distinguish between in which most
output goes to a few people and the case in
which output is evenly divided among all people.

4. GDP is also neutral about the kinds of goods

an economy produces