Applications of Microeconomics

Theory as a Basis for Understanding

the Key Economic Variables
Affecting the Business

Learning Objectives
1.
2.
3.
4.
5.
6.
7.
8.

Understand the significance of microeconomics

theory as applied to business
Know the nature of and the factors affecting the
demand for product other than its price
Distinguish between elastic and inelastic demand
and how they affect the price of goods and services
Discuss the factors affecting the supply of a product
other than its price
Understand the significance of market equilibrium
and pricing
Know the nature of short-run and long-run total cost
Explain the role of money in the economy and the
relationship between its supply and demand
Understand the nature of interest and how interest
rates are determined

Microeconomics
It

focuses on the behavior and

purchasing decisions of individual
and firms

Rationing
It

is an allocation of a limited supply

of a good or resource to users who
would like to have more of it

Demand
It

is the quantity of a good or service

that consumers are willing and able
to purchase at a range of prices at a
particular time
It is actually a schedule of the
amount that would be purchased at
various prices, with all other
variables that affect demand being
held constant
Graphically, there is an inverse

Demand Curve Shift

A

demand curve shifts when demand

variables, other than price, change

Factors Affecting the Demand for

a Product Other than Its Price
Factors
Consumer income and
wealth
Price of other goods and
services
Price of complement
products
Consumer tastes
Group boycott
Size of the market
Expectations of price
increase

Relationship
Generally a direct
relationship
Direct relationship
Inverse relationship
Intermediate relationship
Inverse relationship
Direct relationship
Direct relationship

The Elasticity of Demand

Price Elasticity of Demand is the relationship

between percent change in quantity demanded and
percent change in price
a)Perfectly inelastic. Despite an increase in price,
consumers still purchase the same amount
b)Relatively inelastic. A percent increase in price
results in a smaller percent reduction in sales
c)Unitary elasticity. The percent change in
quantity demanded is equal to the percent change
in price
d)Relatively elastic. A percent increase in price
leads to a larger percent reduction in purchases
e)Perfectly elastic. An infinitesimally small change
in price results in an infinitely large change in

Supply
The

Law of Supply is a principle that,

there will be a direct relationship
between the price of a good and the
amount of it offered for sale

Supply Curve Shift

A

supply curve shift occurs when

supply variables, other than price,
change.

Factors Affecting the Supply of

a Product Other than Its Price
Factors
Prices of other goods
Number of products
Government price
controls
Price expectations
Government subsidies
Change in production
costs or technological
advances

Relationship
Inverse relationship
Direct relationship
Serves as a limitation
Direct relationship
Direct relationship
Inverse relationship

Elasticity of Supply

Elasticity of Supply measures the percentage

change in the quantity supplied or a product
resulting from a change in the product price. It
is calculated as follows:

Supply is said to be elastic if Es > 1, unitary

elastic if Es = 1, and inelastic if Es < 1
Elastic supply means that, a percentage
increase in price will create a larger percentage
increase in supply

Market Equilibrium and

Pricing
A

market is an abstract concept that

encompasses the forces generated by the
buying and selling decisions of economic
participants
Equilibrium is a state of balance between
conflicting forces
Before a market equilibrium can be attained,
the decisions of consumer and producers
must be coordinated. Their buying and
selling activities must be brought into
harmony with one another

Market Equilibrium and

Pricing
Short-run

market equilibrium is a
time period of insufficient length to
permit decision makers to adjust
fully to a change in market condition
Long-run market equilibrium is a
time period of sufficient length to
enable decision makers to adjust
fully to a market change

Impact on Equilibrium of Shifts in

the Supply and Demand Schedule
Market

prices will bring the conflicting

forces of supply and demand into balance
When a market is in long-run equilibrium,
supply and demand will be in balance and
the producers opportunity cost will equal
the market price
Changes in consumer income, prices of
closely related goods, preferences and
expectations as to future prices will cause
the entire demand curve shift

Impact on Equilibrium of Shifts in

the Supply and Demand Schedule
Changes

in input prices, technology and other

factors that influence he producers cost of
production will cause the entire supply curve to shift
The constraint of time temporarily limits the ability
of consumers to adjust to changes in prices
When a price is fixed below the market equilibrium,
buyers would want to purchase more than what
sellers are willing to supply
When a price is fixed above the market equilibrium
level, sellers will want to supply a larger amount
than buyers are willing to purchase at the current
price

Short-run Total Cost

Variable

Cost (VC)
Average Fixed Cost (AFC)
Average Variable Cost (AVC)
Marginal Cost (MC)
Average Total Cost (ATC)
Fixed Cost (FC)

Long-run Total Cost

In

the long-run, all inputs are

available because additional plant
capacity can be built. If in the longrun, a firm increases all production
factors by a given proportion, there
are the following three possible
outcomes:
1.Constant returns to scale
2.Increasing returns to scale
3.Decreasing returns to scale

Profits
There

are two different types of profit:

1.Normal profit. The amount of profit
necessary to compensate the owners for
their capital and/or managerial skills. It
is just enough profit to keep the firm in
business in the long-run
2.Economic profit. The amount of profit in
excess of normal profit. In a perfectly
competitive market, economic profit
cannot be experienced in the long-run

Production
A

good should be produced and sold

as long as, the marginal cost (MC) of
producing the good is less than or
equal to the marginal revenue (MR)
from the sale of that good

Marginal Product
The

marginal product is the

additional output obtained from
employing one additional unit of a
resource
To be competitive, management
must produce the optimal output in
the most efficient manner. The cost
of production in the long-run is
minimized when the marginal
product (MP) per peso of every input

The Role of Money in the

Economy
Money

is any item or commodity that

is generally accepted as a means of
payment for goods and services of
for repayment of debt, and that
serves as an asset to its holder
Money serves three main purposes:
1.Medium of Exchange
2.Store of Value
3.Standard Value or Unit of Aaccount

The Supply and Demand for

Money
Money

facilitates the flow of

resources in the circular model of
macroeconomy. Not enough money
will slow down the economy, and too
much money can cause inflation
because of higher price levels.

The Money Supply

The

Key Measures for the Money Supply are:

M1. The narrowest measure of the money
supply. It includes currency in circulation
held by the nonblank public, demand
deposits, other checkable deposits and
travelers checks.
M2. This measure includes money held in
savings deposits, money market deposit
accounts, noninstitutional money market
mutual finds and other short-term money
market assets

The Money Supply

M3. This measure includes the
financial institutions
L. This measure includes liquid
and near-liquid assets

The Demand for Money

The

sources of the Demand for Money are:

Transaction demand. Money demanded
for day-to-day payments through balances
held by households and firms.
Precautionary demand. Money
demanded as a result of unanticipated
payments.
Speculative demand. Money
demanded because of expectations about
interest rates in the future.

The Impact of Money

In

the macroeconomic short-run, some prices

will be inflexible
The BSPs monetary policy has an immediate,
short-run impact on the economy
Monetary policy can be applied in the shortrun when the economy faces an inflationary
gap
If the economy is at its long-run equilibrium,
and the BSP increases the money supply, it
will increase aggregate demand

The Quantity Theory of

Money

The quantity theory of money holds that

changes in the money supply (MS) directly
influences the economys price level, but
nothing else. This theory follows from the
equation of exchange:
wher M
e
V
P
Y

= quantity of money
= velocity of money
= price level
= real GDP

Interest Rates
The

interest rates link the future to

the present. It allows individuals to
evaluate the present value (the
value today) of future income and
costs. In essence, it is the market
price of earlier availability
In a modern economy, people often
borrow funds to finance current
investments and consumption.

How Interest Rate are

Determined
Interest

rates are determined by the

demand for and supply of loanable
funds.
Investors demand finds in order to
finance capital assets tat they
believe will increase output and
generate profit. Simultaneously,
consumers demand loanable funds
because they have a positive rate of
time preference

Determining the Interest

Rate

Money Market
Equilibrium

How Interest Rates are

Determined
According

to Keynesian theory, the

rate of interest is determined as a
price in two markets:
1. Investment funds. The rate of
interest balances the demand for
funds and the supply of funds
2. Liquid assets. Because borrowers
require cash in the long-term, they
are willing to compensate lenders
for giving up liquidity

The Nominal or Money Rate

vs. The Real Rate of Interest
During

a period of inflation, the

nominal interest rate or money rate
of interest is misleading indicator of
how much borrowers are paying and
lenders are receiving

Interest Rates and Risk

There

are many interest rates. There

is the mortgage rate, prime interest
rate, consumer loan rate and the
credit card rate to name a few
Interest rates in the loanable funds
market will differ mainly because of
differences in the risks associated
with the loans

Interest Rates and Risk

The

money rate of interest on a loan has

three components:
1. Pure interest. The real price one must
pay for earlier availability
2. Inflationary-premium. Reflects the
expectation that the loan will be
repaid with pesos of less purchasing
power as the result of inflation
3. Risk-premium. Reflects the probability
of default

Effect of Change in Interest

Rates
Short-term

interest rates are

relevant for loans with a relatively
short length for repayment while
long-term interest rates on the other
hand, are relevant for loans such as
long-term corporate borrowing and
10-20-30 year fixed rate motgages.