Chapter I

Introduction to Economics, Microeconomics and Economic Models

INTRODUCTION
You may be wondering why we need to study economics especially our course (i.e.
microeconomics. The answer is very simple- we use it every day. We often hear news reports on
fuel prices going up and down. We have encountered transport strikes where drivers demand for
rollback in gasoline prices or a fare increase. In our daily trip to work or school, we experience
heavy traffic. We might think that roads are not wide enough, or there are just too many vehicles
plying the streets. We regularly go to grocery stores even there is a pandemic to shop for our daily
needs. There are times when we observe several items on sale and feel that either those items are
near expiration or the store had overstocked. It is difficult to miss these daily experiences, and we
cannot deny their relation to economics. It is possible that there is an increase in fuel prices as a
consequence of an oil price increase in the world market. Heavy traffic is a result of an unregulated
increase in the volume of vehicles and the government’s insufficient resources to finance the
construction of new roads. The discounted prices of goods can be levelled-off by new stocks of
products at regular prices. So think about it: is it a waste of time to learn economics?

INTENDED LEARNING OUTCOMES

After studying this module, the students will be able to:

1. Define economics and explain the role in business and to the economy as a whole.
2. Differentiate microeconomics from macroeconomics by citing an examples.
3. Describe the different economic models and find how it is applied to the various types of
businesses.
4. Differentiate and identify economic theories from economic models.

DEFINITION OF TERMS

• Economics defined as the study of the proper allocation and efficient utilization of scarce
productive resources to produce commodities for the maximum satisfaction of unlimited wants
and needs.

• Microeconomics deals with the behaviour of individual components such as household,

firm, and individual owner of production. It focuses on the behaviour of a particular unit of the
economy such as consumers, producers, and specific markets. In microeconomics, you will often
encounter terms like consumer’s behaviour, production theory, cost and profit, and the market
structures.

• Macroeconomics deals with the behaviour of economy as a whole with the view of
understanding the interaction between economic aggregates such as unemployment, inflation and
national income. In macroeconomics, the initial discussions begin with how growth and output are
measured and how multipliers work. Labor, employment, and inflation are included for long-term
effects, as well as monetary, fiscal and trade policies.
 • Economic theory is a preposition about certain related variables that scientifically
explain a certain phenomenon. It tries to explain economic phenomena, to interpret why and how
the economy behaves and what is the best to solution-how to influence or to solve these economic
phenomena.

• Economic model is essentially a simplified framework for describing the working of the
economy. It is used to illustrate, demonstrate, and represent a theory or parts of it. It simplifies an
explanation or description of a certain phenomenon, often employing graphs, diagrams, or
mathematical formulae.

• Circular Flow Diagram pictures the economy as consisting of two groups- households
and firms-that interact in two market; goods and services market in which firms sell and
households buy and the labor market in households sell labor to business firms or other employees.

• Production Possibility Frontier (PPF), Production Possibility Curve (PPC), or a

Production Possibility Boundary (PPB) is a curve which shows various combinations of the
amounts of two goods which can be produces within the giver resources and technology/ a
graphical representation showing all the possible options of output for two products that can be
produced using all factors of production, where the given resources are fully and efficiently utilized
per unit time.

Methodologies of Economics

Every profession and field of studies utilizes tools in order for them to come up with the best
decisions. In case of economics, the main tool use is the model. Economic model is a representation
of the actual scenario.
Economic models can be presented in three forms; the tabular, graphical and mathematical
or econometric.
1. Tabular model. This is economic model presented in table. Table has column and rows
forming a cell. In economics, tabular form of model is also known as schedule.

Table 1.1
Total Cost Schedule
Quantity Total Cost

0 25

5 50

10 75

15 100
 2. Graphical Model. This is economic model presented using graph. There are several types
of graphs as discussed in your statistics class however in the field of economics the most common
form of graphical model is the line graph and it is called as curve.

Figure 1.1
Total Cost Curve
3. Mathematical or econometric model. This model is in the form of an equation. When
we say equation, it is a combination of numbers (coefficient or constant), letters
(variables) and an equal sign (=). In case of mathematical and econometric model, there
is still a difference between the two; econometric model have error term (Ԑ) while
mathematical model doesn’t have.

TC =25 + 5Q (equation 1. Mathematical Model)

TC = 25+ 5Q + Ԑ (equation 2. Econometric Model)

This form of model is commonly called as function.

Since economic model is a tool used for decision making, it is important that we
understand the three general assumptions of the model. Assumptions are set of conditions that need
to satisfy to make the model valid. These three assumptions are:

1. Ceteris paribus assumption. It is a Latin word which means holding other variable
constant. In some books, it is also defined as remaining other things the same. This assumption is
a nature of all economic models. All of the economic models have variables in which the model
merely focuses. On our example above (total cost model), the main variables are total cost and
quantity. Under the ceteris paribus assumption, merely quantity is the concept that varies and affect
the total cost and other factors that might affect total cost, we assume all of that as constant. This
is for us to isolate the effect of the specific independent variable to dependent variable.
2. Optimization assumption. Every economic model goal is to optimize something. When
we say optimization, we either maximize or minimize something. We maximize all of the things
that are favourable to decision maker while we minimize all things that are unfavourable for
decision maker. Examples of things that we maximize are revenue and resources while we usually
minimize the cost and risk.
3. Positive versus Normative Economic Statement. The difference between
microeconomics and macroeconomics is based on the degree of details considered. Another
valuable feature is the reason in examining a problem. Positive economics relates to what is. It is
an economic analysis that explains what happens in the economy and why, without making any
recommendations to economic policy, or in simple idea, it deals with how should be verified by
facts. Normative economics concerns itself with what should be. It is an economic statement that
makes recommendation to economic policy. This economic statement is employed to make value
judgments about the economy and suggests solutions to economic problems. Instead of restricting
its involvement on facts, it extends to the specific actions that we should do to address the issues
that depend on our values.

Analytics using Economic Model

Economic models can be used in three levels; descriptive, predictive and prescriptive. These
are the steps of making decision using economic models.
1. Descriptive Analytics. This step covers the description of economic model. We
commonly put emphasize on the highest and lowest point of the curves or schedule, the relationship
exist between the two or more variables, the slope and coefficient of the model.
2. Predictive Analytics. This step covers the forecasting of possible outcomes after
describing the economic model. Based on the relationship establish, we can identify the possible
effect of independent variable to dependent variable once change.
3. Prescriptive Analytics. This step is the process of making recommendations and
suggestions to attain the main goals of economic model which is to optimize.

Circular Flow Diagram

For us to better understand how economy work, it is important to understand the circular
flow diagram. It is a depiction of how money and products are exchanged within an economy. A
circular flow diagram might be used by a business to show how a specific series of exchanges of
goods, services and payments make up the building blocks of a given economic system of interest.
 Figure 2
Circular Flow Diagram

The economy can be thought of as two cycles moving in opposite directions. In one
direction, we see goods and services flowing from individuals to businesses and back again.
This represents the idea that, as laborers, we go to work to make things or provide services that
people want.

In the opposite direction, we see money flowing from businesses to households and back
again. This represents the income we generate from the work we do, which we use to pay for
the things we want.

Both of these cycles are necessary to make the economy work. When we buy things, we
pay money for them. When we go to work, we make things in exchange for money.

The circular flow model of the economy distills the idea outlined above and shows the
flow of money and goods and services in a capitalist economy.

What Are Circular Flow Diagrams?

We all need to buy goods. Sometimes those goods are groceries, while other times those
goods are clothing for an important event. Whatever the goods might be, purchasing them forms a
crucial piece in a functioning economy.
Simply put, each time we buy a good we are contributing to the economy. In this lesson,
we'll look at how those purchases are just part of a bigger piece of the economic puzzle. You see,
the economy works in a circular motion known as the circular flow diagram in economics.
The circular flow diagram is a basic model used in economics to show how an economy
functions. Primarily, it looks at the way money, goods, and services move throughout the economy.
In the diagram, there are two main characters, known as firms and households,
where households represent consumers and firms represent producers.

The Role of Households

Let's take a look at the role of the consumer, or the households. In a circular flow diagram,
households consume the goods offered by the firms. However, households also offer firms factors
so that the firms can produce products for the household to later consume.
For example, households may supply land to produce goods or they may offer themselves in
the form of labor. Households also offer capital, which is a monetary form of investing that helps
firms create products for consumption. All three forms (land, labor, and capital) are offered to
firms so that they can make products that households need and consume.

The Role of Firms

Now let's look at the role of firms. The main function of the firms is to offer goods. In order
to do this, firms take the factors (land, labor, and capital) from households and convert products
into goods and services that consumers need and want. The role of firms makes up the second part
of the circular flow diagram.
Production Possibilities Frontier
Since economics deals with scarcity and used models in making decision, one of the known
economic tools used in allocating resources is the Production Possibilities Frontier (PPF).
Production possibilities frontier (PPF), also known as production possibility curve, indicates the
maximum output combinations of two goods or services an economy can achieve by fully using
all available resources efficiently.
The production possibility frontier indicates the maximum production possibilities of two
goods or services, assuming a fixed level of technology and only one choice between the two.
Producing one good always creates a trade-off over producing another good. In other words, if
more of good A is produced, less of good B can be produced given the resources and production
technology remain constant.
 Figure 2
Production Possibilities Frontier

Hence, the production of one good or service increases when the production of the other
good or service decreases. The PPF measures the efficiency in which the two goods or services
are produced together. In that way, it helps managers to determine the most beneficial mix of
commodities for the business.

Let’s look at an example.

Typically, opportunity cost occurs when a manager chooses between two alternative ways
of allocating business resources. In other words, if one action is chosen, the other action is foregone
or given up. There is a trade-off. Hence, the production possibility frontier provides an accurate
tool to illustrate the effects of making an economic choice.

At any given point of a PPF, the company produces at maximum efficiency by fully using
its resources. At an economic level, this is known as the Pareto efficiency, which suggests that,
when allocating resources, the choice of one will worse off the other. Also, any point inside the
PPF is inefficient because at that point the output is greater than the output that the existing
resources can produce.
For example, a country produces pizza and sugar. If the country decides to ramp up its sugar
production, using the existing fixed resources, it has to lower its pizza production. Hence, at points
A, B, and C, the economy achieves the maximum production possibilities between pizza and sugar.
Points D and E are inside the PPF line and is inefficient because all the resources are not being
used properly. Point F is simply beyond the amount of production attainable with the current level
of resources.

References:
Gabay, Kristoffer . et al. (Second Edition, 2012). Concepts and Principles of
Economics, Rex Book Store, Inc.
McEachern, William A. Economics: A Contemporary Introduction. Thomson
Sourthern West. 2006
Pindyck, Robert S. and Rubinfeld, Daniel L. (Fifth Edition). Microeconomics
Printice-Hall Inc Upper Saddle River, New Jersey.
Remedios P. Magnaye, DBA, Inesio H. Sadiangcolor, MBA, Gemar G. Perez, MBA,
Andres R. Delos Santos, EdD, Joven F. Andrada, BSE, Nemesio Y. Tiongson,
PhD, Rudolfo C. Acosta, PhD. Basic economics : with taxation and land
reform. Jimczyville Publications, ©2014.