19.3 Microeconomics, Macroeconomics, and International Trade

Microeconomics, Macroeconomics, and International Trade

Management Services includes the economic concepts needed to understand an entity's business and industry (syllabus topic 3.0). This section covers microeconomics (demand, supply, elasticity, production, and market structures), macroeconomic measures such as GDP, the business cycle, inflation, and unemployment, monetary and fiscal policy in the Philippine setting, and international trade and foreign exchange.

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1. Microeconomic Principles and Market Structures

The Law of Demand and Supply

• Law of Demand: All else equal (ceteris paribus), as the price of a good increases, the quantity demanded decreases, yielding a downward-sloping demand curve. This relationship is driven by the substitution effect (consumers switch to cheaper alternatives) and the income effect (higher prices erode real purchasing power).
• Law of Supply: As the market price of a good rises, suppliers increase the quantity supplied to maximize profits, yielding an upward-sloping supply curve.
• Market Equilibrium: Occurs at the market-clearing price ($P^*$) where quantity demanded equals quantity supplied ($Q_d = Q_s$).
  • Price Ceilings (legal maximum price set below equilibrium, e.g., rent control): Causes chronic supply shortages and non-price rationing.
  • Price Floors (legal minimum price set above equilibrium, e.g., statutory minimum wage): Creates persistent surpluses.

Price Elasticity of Demand ($E_d$)

Price elasticity measures the responsiveness of quantity demanded to changes in unit selling price.

The Midpoint (Arc) Elasticity Formula

To ensure consistent elasticity coefficients whether price increases or decreases, the arc midpoint formula is standard on the CPALE:

$E_d = \left| \frac{\frac{Q_2 - Q_1}{(Q_1 + Q_2) / 2}}{\frac{P_2 - P_1}{(P_1 + P_2) / 2}} \right|$

Elasticity Classifications and the Total Revenue ($TR$) Test

                               The Total Revenue (TR) Matrix

     Demand Elasticity              Price Change              Total Revenue Impact
   ┌──────────────────────┐      ┌───────────────┐         ┌─────────────────────────┐
   │ Elastic (|Ed| > 1)   │ ──►  │ Price Drops   │  ────►  │ Total Revenue Rises     │
   │                      │ ──►  │ Price Rises   │  ────►  │ Total Revenue Falls     │
   ├──────────────────────┤      ├───────────────┤         ├─────────────────────────┤
   │ Inelastic (|Ed| < 1) │ ──►  │ Price Drops   │  ────►  │ Total Revenue Falls     │
   │                      │ ──►  │ Price Rises   │  ────►  │ Total Revenue Rises     │
   ├──────────────────────┤      ├───────────────┤         ├─────────────────────────┤
   │ Unitary (|Ed| = 1)   │ ──►  │ Price Shifts  │  ────►  │ Total Revenue Unchanged │
   └──────────────────────┘      └───────────────┘         └─────────────────────────┘

• Elastic Demand ($|E_d| > 1$): The percentage change in quantity demanded exceeds the percentage change in price. Reducing price increases total revenue ($TR = P \times Q$) because volume expansion outweighs the price reduction.
• Inelastic Demand ($|E_d| < 1$): The percentage change in quantity demanded is smaller than the percentage change in price. Raising price increases total revenue because the price gain offsets the modest volume drop.
• Unitary Elasticity ($|E_d| = 1$): The percentage changes are identical; price adjustments leave total revenue unchanged.

Other Key Elasticity Metrics

• Income Elasticity of Demand ($E_y$): $E_y = \frac{\% \Delta Q_d}{\% \Delta \text{Income}}$
  • $E_y > 0$: Normal Good (demand expands with rising income). If $E_y > 1$, it is a Luxury Good; if $0 < E_y < 1$, it is a Necessity Good.
  • $E_y < 0$: Inferior Good (demand contracts as income rises, e.g., low-grade staples).
• Cross-Price Elasticity of Demand ($E_{xy}$): $E_{xy} = \frac{\% \Delta Q_d \text{ of Product X}}{\% \Delta \text{Price of Product Y}}$
  • $E_{xy} > 0$: Substitute Goods (a price rise in butter increases margarine demand).
  • $E_{xy} < 0$: Complementary Goods (a price rise in printers reduces ink cartridge demand).
  • $E_{xy} = 0$: Independent Goods.

Production Theory and Diminishing Marginal Returns

• Law of Diminishing Marginal Returns: In the short run, when successive units of a variable input (e.g., labor) are added to fixed productive inputs (e.g., plant capacity), the Marginal Product ($MP = \Delta TP / \Delta L$) of the variable factor eventually declines.
• Profit Maximization Rule: A firm in any market structure maximizes operating profit by producing at the output volume where Marginal Revenue equals Marginal Cost ($MR = MC$).

Comparative Market Structures

Oligopoly Note: Characterized by the Kinked Demand Curve model, which explains price rigidity: competitors match price cuts (inelastic response) but ignore price increases (elastic response).

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2. Macroeconomic Concepts and National Income

Gross Domestic Product (GDP)

GDP represents the total monetary market value of all final goods and services produced within a nation's geographical borders during a specified time interval.

The Expenditure Approach

$GDP = C + I + G + (X - M)$

• $C$: Personal Consumption Expenditures.
• $I$: Gross Private Domestic Investment.
• $G$: Government Consumption and Gross Public Infrastructure Outlays.
• $(X - M)$: Net Exports (Gross Exports [$X$] minus Gross Imports [$M$]).

Nominal vs Real GDP

$\text{Real GDP} = \frac{\text{Nominal GDP}}{\text{GDP Deflator}} \times 100$ Real GDP isolates true physical output changes by eliminating price-level inflation.

The Macroeconomic Business Cycle

Progresses through four recurring phases: Expansion (rising real GDP, falling unemployment), Peak (capacity constraints, inflationary pressures), Contraction / Recession (officially two consecutive quarters of negative real GDP growth, rising unemployment), and Trough (the cyclical bottom where production stabilizes before recovery).

Inflation and Unemployment

• Types of Inflation:
  • Demand-Pull Inflation: Aggregate spending exceeds productive capacity ("too much money chasing too few goods").
  • Cost-Push Inflation: Aggregate supply shifts leftward due to surging production input costs (oil shocks, imported raw material spikes, wage push).
  • Consumer Price Index (CPI): Measures the price of a standard market basket of consumer goods. Inflation rate = $\frac{CPI_t - CPI_{t-1}}{CPI_{t-1}} \times 100$.
• Classifications of Unemployment:
  • Frictional: Voluntary transitional unemployment (graduates entering the workforce, workers changing jobs).
  • Structural: Long-term mismatch between workers' skillsets and modern employer requirements caused by technological advancement.
  • Cyclical: Unemployment resulting directly from macroeconomic downturns and deficiencies in aggregate demand.
  • Natural Rate of Unemployment: Frictional + Structural unemployment. Exists when Cyclical Unemployment is zero (Full Employment).

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3. Monetary and Fiscal Policy in the Philippine Setting

Macroeconomic stabilization in the Philippines is managed jointly through monetary policy (administered by the Bangko Sentral ng Pilipinas) and fiscal policy (administered by the National Government via the DOF and DBM).

                             Macroeconomic Policy Framework

               ┌───────────────────────────┴───────────────────────────┐
               ▼                                                       ▼
     [ Monetary Policy ]                                     [ Fiscal Policy ]
     Bangko Sentral ng Pilipinas (BSP)                       Department of Finance (DOF) & DBM
     Mandate: Price Stability                                Mandate: Public Finance & Allocation
     Tools:                                                  Tools:
       • Target RRP Benchmark Rate                             • Government Spending (Infrastructure)
       • Reserve Requirement Ratio (RRR)                       • Tax Reform (TRAIN, CREATE Acts)
       • Open Market Operations (OMO)                          • Sovereign Borrowing & Deficit Management

Monetary Policy Tools of the Bangko Sentral ng Pilipinas (BSP)

Under Republic Act No. 7653, as amended by Republic Act No. 11211 (The New Central Bank Act), the BSP's primary objective is to maintain price stability conducive to balanced and sustainable economic growth.

1. Target Reverse Repurchase (RRP) Rate: The benchmark overnight policy interest rate. When inflation exceeds the target band ($2\% - 4\%$), the Monetary Board executes a Contractionary (Hawkish) stance by raising the RRP rate, elevating commercial borrowing rates, curbing credit creation, and dampening aggregate demand.
2. Reserve Requirement Ratio (RRR): The mandatory proportion of deposit liabilities that commercial banks must hold in reserve with the BSP. Raising the RRR contracts loanable bank funds; lowering the RRR injects liquidity into the banking system.
3. Open Market Operations (OMO): Direct purchase or sale of government and BSP-issued securities in the secondary market to adjust banking liquidity.
4. Rediscount Facility: Standing credit window through which banks borrow short-term funds against commercial customer paper.

Fiscal Policy

• Expansionary Fiscal Policy: Increasing public infrastructure disbursements (e.g., "Build Better More") or enacting tax reductions to stimulate aggregate economic output during recessions, generating budget deficits.
• Contractionary Fiscal Policy: Curbing public expenditures and augmenting tax collections to reduce fiscal deficits and contain overheating.
• The Crowding-Out Effect: Heavy public deficit borrowing drives up domestic interest rates, dampening private capital investment.

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4. International Trade and Foreign Exchange

• Absolute advantage: a country produces a good with fewer resources than another country. Comparative advantage: a country produces a good at a lower opportunity cost. Trade benefits both countries when each specializes according to comparative advantage, even if one has an absolute advantage in everything.
• Trade barriers: tariffs (taxes on imports), import quotas, subsidies to local producers, and non-tariff barriers such as licensing and standards. Tariffs raise domestic prices, protect local producers, and reduce consumer surplus.
• Balance of payments: the current account (trade in goods and services, primary income, and secondary income such as overseas Filipino workers' remittances), the capital account, and the financial account (direct investment, portfolio investment, and other investment). Changes in the BSP's gross international reserves reflect the overall balance.
• Exchange rates: the Philippines follows a market-determined (floating) exchange rate, and the BSP may intervene to smooth excessive volatility.

Purchasing power parity holds that exchange rates adjust so that identical goods cost the same across countries, so a country with higher inflation tends to see its currency depreciate. Interest rate parity links the forward premium or discount to the interest rate differential between two currencies.