Nature of Economics

BASIC ECONOMICS, LAND REFORM AND TAXATION

K n o w l e d g e i s t h e g r e a t e s t c r e a t o r o f w e a l t h . P a g e | 1

INTRODUCTION: NATURE OF ECONOMICS

An economy begins with the desires of the people in the society for material

goods and services. Like in the movie, the two main characters put on to their Bucket

List's exotic backdrops — the Great Pyramids, the Taj Mahal, an African safari —to

see and to visit. This are all material desires.

Notice that we use the word "desires" or "wants", rather than "needs". We will not concern

ourselves with the question of what it is that people truly need. Also notice that the focus is

on material goods and services. We will be concerned with food, shelter, clothing, health

care, recreation, entertainment, and so forth; we shall not be concerned with psychological

desires such as love, power, or respect. (Any product that satisfies people's desires is

called a "good" or a "service". The act of obtaining these material goods and

services is called “consumption”.)

Modern Economics makes two assumptions about people's desires for material goods and

services.

First, they are insatiable . No matter how many goods and services people have,

they still want more. Today, even the poorest Filipinos have more goods and

services than could have possibly been imagined by people living 200 years ago.

Yet, we still desire more and more.

Morgan Freeman himself says he has movies he still wants to make. Ellen

DeGeneres wants to learn Spanish; Beyoncé, a lifelong dancer, crossed

ballet off her list (too hard) but added learning Arabic.

Second, they are rational . People's desires are not to be questioned. I desire the

things I desire for my own reasons. You desire the things you desire for your own

reasons. I know what is best for me and you know what is best for you.

In order to satisfy their desires for consumer goods, the people in the society must

engage in production.

FACTORS OF PRODUCTION

To produce, people begin with natural resources . Nature provides land, minerals,

trees, water, fish, animals, and so forth. Usually the people must do something to



these natural resources to satisfy their desires --- harvest the fruits and vegetables,

dig the minerals, cut the trees, catch the fish, and so forth.

The productive contribution made by the people is called labor . However, with

natural resources and labor alone, the society will not be able to satisfy the desires of

the people very well. From earliest times, people have learned that they could satisfy

their desires better by taking some of the natural resources and converting them into

a form that will not meet desires today but which will allow greater production in the

future.

Thus, wood and iron are used to make a hammer. The hammer is not desired by

anyone for its own sake, but it allows people to build more of those things they do

desire. We call this indirect use of natural resources “capital goods”. Do not

confuse this meaning of the word "capital" with other meanings. In business use, for

example, capital sometimes refers to the money invested by the owner of a business.

Capital here refers to goods made by people for the purpose of increasing

production. Examples are machines, tools, equipment, and factory buildings.

Finally, there is a need for someone to recognize the desires that people have and

then bring together the appropriate natural resources, labor, and capital goods to

meet these desires. There is risk involved; if one does not recognize the desires

correctly or if one organizes the production inefficiently, considerable loss could

result. So, for example, Steve Wozniak and Steven Jobs recognized a desire of some

people in the society --- a desire for a computer that could be operated at home.

They didn't just develop such a computer. They started a company --- Apple. With

others, they obtained the natural resources, hired and trained the workers, bought

the necessary machinery, and organized the production process. The success of the

Apple II allowed both of them to have wealth valued in the billions of dollars. A person

who undertakes this activity is called an entrepreneur . Successful entrepreneurs

become famous. So Ray Kroc (MacDonalds), Bill Gates (Microsoft), Sam Walton (Wal-

Mart), Henry Sy (SM) and many others are very well known. Unfortunately, most

entrepreneurs are not so successful.

Natural resources, labor, capital, and entrepreneurship are called the factors of

production.



You Also Need To Know

The factors of production determine the maximum amounts of the various goods and

services that can be produced at the present time. But people's desires for these goods and

services are insatiable. As a result, the desires always exceed the ability to meet

them, a phenomenon known as scarcity .

Defining our Real Basic NEEDS vs WANTS

1. Food. All we need is nutritious food cooked at home. Food becomes want when we

decided to eat regularly at fancy restaurants and food chains.

2. Clothing. We need clean, neat and suited for our daily activity. We do not need expensive

and designer’s clothes.

3. Housing and Utilities. A room or a house big enough for the family, a simple basic

furniture such as stove, TV set and telephone or cp. A big house, expensive furniture, a

home entertainment system and sophisticated cp are wants.

4. Transportation. Enough money to go to work and return home is what we need. Owning

bicycle, motorcycle or car are mostly wants.

5. Education. Quality education need not necessary to be expensive. Going to prestigious

school is mostly wants.

6. Leisure. When the activity is for free or almost for free it is a need, like watching free

concerts, borrowing books, going to work, etc. While those expensive and luxurious trip,

vacation and having big parties are usually wants.



Living our life without our basic needs makes life more difficult and not worth

living. Look around you and you will see that a lot of people are living without

these basic needs.

This is one of the reasons why we study economics: To make sure that you will be

able to afford these needs throughout your life.

Economic Terms

Economics: It is the study of proper allocation of scarce resources to satisfy unending

human wants and needs.

Needs: are man’s basic requirements to be able to live

Wants: something desired, not essential

Scarcity: when there are not enough resources available to meet the needs and

wants of everyone. Unlimited Needs & Wants + Limited Resources =

SCARCITY

The fact of scarcity forces every society to have to answer three basic questions.

As we learned in the previous chapter, the factors of production determine the maximum

amounts of the various goods and services that can be produced. But people's desires for

these goods and services are insatiable. As a result, the desires always exceed the

ability to meet them, a phenomenon known as scarcity. Scarcity generates the

fundamental problem faced by all societies. Because of scarcity, every society must answer

three major questions:

1. The Three Questions Every Society Must Answer

(1) What to Produce?

In a world of scarcity, any choice to produce something is also a choice not to produce

something else. Production of all of the goods and services that are desired is simply not

possible. The value of whatever is sacrificed when a decision is made is called



"opportunity cost". Sometimes, opportunity cost can be easily measured in money. If

you choose to spend P15 on a CD, you are sacrificing P15 worth of other goods or services

that you could have bought. In other situations, opportunity cost may be harder to measure.

Your decision to take Economics this term has an opportunity cost. The most important

opportunity cost is the value of the time you will sacrifice. If you would have worked during

this time, your sacrifice can be measured easily; you sacrificed the wages you would have

earned. But if you would have watched television, slept, or spent time with your children or

friends, it is harder to put a dollar value on your sacrifice. But that does not change the fact

that you have sacrificed time to take Economics.

(2) How to Produce?

Having decided what to produce, we must now determine how to produce it. This

means that we must decide on the combinations of the factors of production that

we will use. Goods produced mainly by labor are called labor-intensive. Goods produced

largely by machinery and equipment are called capital-intensive. Some goods may be

natural resource intensive, technology-intensive, energy-intensive, skill-intensive, and so

forth. There are usually many different ways to produce a given product. Rice grown in

China is both labor-intensive and water-intensive. But rice grown in California is capital-

intensive as well as water-intensive. Similarly, cotton grown in the American South was

labor-intensive while cotton grown in California is capital-intensive. Recently, California's

main growth industries have been technology-intensive and skill-intensive rather than

capital-intensive.

(3) For Whom to Produce?

Once it has been decided which goods and services are to be produced, it must be

decided who will have these goods and services. Remember that goods and services are

scarce; not every desire can be satisfied. Production of goods or services that will meet my

desires may mean less of the goods or services that would meet your desires and vice versa.

We are in conflict. Somehow, we must resolve this conflict in a manner that allows us to

exist as part of the same society.



In an economy such as that of the Philippines, our incomes determine which of our

desires can be satisfied. In a later chapter, we shall discuss the factors that determine why

some people have much higher incomes than others have.

2. Economic Systems

Every society must answer these three questions: what to produce, how to produce, and

for whom to produce. Usually people organize in some way to find the answers. Such an

organization of people is called an economy. And, of course, the study of an economy is

called Economics . There are two extreme types of economies: command economies and

market economies. Most existing economies are some combination of the two types.

A command economy, or hierarchy, describes itself. A commander, usually

the government, decides what will be produced, how it will be produced,

and who will get the goods and services that are produced. The former Soviet

Union was a good example of a command economy. The government decided which

goods or services would be produced (for the most important products). This came

as an annual plan. The plan would be very detailed. So, for example, if you

managed a shoe company, the plan might specify how many size 6 shoes that were

black you must produce, how many size 8 shoes that were green you must produce,

and so forth. The plan was more than a goal; there were significant penalties to the

company management for failing to meet the plan quotas and significant rewards for

succeeding.

The plan also specified how goods and services were to be produced. Again, if you

were the manager of a shoe company, you might be told how much leather you could

have and where you must get it, how many workers you may have, how much

machinery you may have, and so forth. One feature of the former Soviet economy

was that the "what" and the "how" often did not reconcile. For example, it might not

have been possible to produce the number of size 6 shoes that you were required to

produce with the amount of leather you were allowed to have.

This led to behaviors that were not intended by the government. For example, the

manager would have shoes produced that were actually size 3 but have size 6 labels

put on them. Or the manager would record leather as "lost in shipment" and then



hoard it for use at a later time when there would not be enough. Even in the former

Soviet Union, the government did not decide the "for whom" question. Generally,

people would stand in line for the goods and services; those in the line first would

have their desires met first. However, there was one exception: if you were a

member of the communist party, you came first.

In the United States, a good example of such a command economy is the military:

the commanders give the orders on most matters and others are merely expected to

follow. Many large companies in the United States and in Europe copied this military

command principle. Another example of a command economy involves the control

over land in the United States. In the eleven western states, more than 40% of all

land is under the control of the United States government (most commonly the Forest

Service or the Bureau of Land Management). These agencies determine who is

allowed to graze animals on the land, how much grazing can be done, and what price

is to be paid for grazing rights. The Forest Service also determines how many trees

can be cut, who can cut them, and the price to be paid to cut them. Hunting, fishing,

access to national parks, and so forth are also controlled mainly by this command

economy principle.

The other extreme type of economy is the market economy. Markets are

merely places where buyers come to buy and sellers come to sell. The

market may be a physical place, such as the Philippine Stock Exchange. Or it may

not be a physical place; for example, foreign exchange market transactions take

place through communications via telephone and computers between banks and

other dealers around the world. In a market economy, it is through the

interaction of the buyers and the sellers that the questions of "what to

produce", "how to produce", and "for whom to produce" are answered. How

markets do this is a main topic of this course. There has been a major change in the

world since the late 1970s: market economies are replacing command economies.

The former communist countries, including all of Eastern Europe as well as China, are

substituting markets for command. Countries such as Mexico, the countries of South

and Central America, and the countries of Asia are also increasing their use of

markets. And, in the United States, large, hierarchical corporations are losing ground

to smaller, more entrepreneurial companies.



Do not confuse the terms market economy and command economy with the terms

“ capitalism” and “socialism” . Literally, these latter terms refer to ownership of

capital goods. As we saw in the previous chapter, in capitalism, capital goods are

owned by private individuals, called capitalists. In socialism, capital goods

are owned by the government. In both types of systems, private individuals own

consumer goods, such as clothes and televisions. Most economies are mixtures of

market and command and also are mixtures of capitalism and socialism. But

Philippines is basically a market economy that is capitalist. The former

Soviet Union was basically a command economy that was socialist. China

today is becoming more and more of a market economy but is still basically

socialist. Nazi Germany was basically a command, capitalist economy. So

there are many possible combinations.

3. Rational Decision Making

Economic thinking makes a specific assumption about the nature of people: people

are rational, self-interested, maximizers. Such a being is often called homo

economicus (economic man). As noted in the last chapter, "rational" means that each

person knows what is best for himself or herself. "Self-interested" does not mean that

people only act for themselves and never care about others.

But it does mean that people do act in their self-interest as they perceive it. A

"maximizer" acts to get the most possible. We assume that consumers act to maximize

the satisfaction they receive from the goods and services they buy. We assume that

businesses attempt to maximize the profits they earn and that workers attempt to maximize

the wages (or other benefits) they earn.

THE LAW OF DEMAND



In this chapter, we shall focus on the quantity of a given product that buyers wish to buy ---

called the demand. What factors explain the quantity demanded of a given product by

buyers?

One of the key factors is certainly the price of the product. Think of buying rice. As the

price rises for commercial rice, many consumers tend to lessen their demand for it. We can

generalize it with the following statement: as the price of the product rises, the

quantity demanded of that product falls, and vice versa. The statement is typically

referred to as the law of demand .

NON PRICE DETERMINANTS OF DEMAND

One of the factors that affect the demand for a product is the price of that product. There

are certainly other factors. In fact, there are seven (7) other factors. These are called the

determinants of demand. Let us examine them one at a time.

1. Consider the demand for new homes. You want a new home and choose one you

like. The price is $500,000. You don't buy. One reason is that your income is not

large enough to be able to afford this amount. Therefore, income must be one of

the factors that affect the demand for a given product. Normally, we expect that as

one's income rises (falls), the demand for a product will rise (fall).

2. Return now to your decision to buy a new home. Assume that you are willing to pay

the price and have sufficient income. What other factors might enter into your

decision? One might involve the method you will use to pay for this home ---

borrowing money. The price of borrowing money is called the interest rate. The

interest rate is one example of the price of a complement. A complement is a

different good that goes together with the one under consideration. Homes

and borrowing money tend to go together. So do bread and butter, coffee and sugar,



gasoline and automobiles, homes and furniture, peanut butter and jelly, and many

other examples. What happens to the demand for new homes if the interest

rate rises? The answer, of course, is that it falls. It is also likely that the demand

for butter will fall if the price of bread rises, the demand for automobiles will fall if the

price of gasoline rises, and so on. Therefore, our relationship is: if the price of the

complement rises (falls), the demand for the product (homes) falls (rises).

3. Complements are different goods that are related to the one we are considering.

There is another kind of relationship: the products may be substitutes.

Substitutes are different goods that compete with the one under

consideration. Coca-Cola and Pepsi Cola are substitutes, as are butter and

margarine, American cars and Japanese cars, Wendy’s and Burger King, baseball and

football (in the fall) and many other examples. In our example, the main substitute

for homes is apartments. What happens to the demand for homes if the price

of apartments falls? If apartments rented for P1500 per month, more people

would want to live in apartments and fewer in homes. It is also likely that the

demand for Coca Cola would rise (fall) if the price of Pepsi Cola rises (falls), the

demand for American cars would rise (fall) if the price of Japanese cars rises (falls),

the demand for Wendys burgers would rise (fall) if the price of Burger King burgers

rises (falls), and so on. Therefore, the relationship is: as the price of the

substitute (apartments) rises (falls), the demand for the product (homes)

rises (falls).

4. We have thus far discussed three factors affecting your decision to buy a home

other than the price of the home: your income, the price of complements such as

borrowing money and buying furniture, and the price of substitutes such as

apartments. One obvious other factor involves the fact that you like homes! This we

call tastes or preferences . It involves the fact that there are certain psychological

reasons for liking or disliking a particular good. Our principle is: the more (less) we

like a good or service, the greater (less) is our demand for it. So what do you

think happened to the demand for red wine when the television show 60 Minutes did

a report that drinking red wine moderately every day lowered cholesterol and

therefore lowered the risk of having a heart attack?

5. In the case of homes, we have often observed people buying not just one home but

five or six. This does not mean buying one in Beverly Hills, another in Aspen

Colorado for skiing, and another in Hawaii for surfing. It means several homes in the

same area. Why would one do this? One answer is that the buyer expects the



price to rise in the near future or Future Price expectation of the consumer.

Of course, the buyer does not know that the price will rise. So, there is a gamble

here; the buyer expects the price to rise! These expectations affect our demand for

many products. For example, people commonly buy stock or foreign monies because

they expect the prices of the stock or of the foreign money to rise soon. (Do not

confuse this with the last section where we considered how buyers respond when the

price actually does change. Here, the price has not changed; buyers simply expect

that it will change soon.) Our principle here is: if buyers expect the price to rise

(fall), the demand rises (falls) today.

6. There are other kinds of expectations one might have that will affect the demand

for products. If one expects that the product will soon be unavailable, the

demand will rise today . This was the case for gasoline in the early 1970s and

again in September of 2001. Expecting that gas stations would soon be out of

gasoline, buyers rushed to stock-up. Also, if one expects that one's income will

fall, the demand for most products will fall. During recessions, other people are

losing their jobs or otherwise having their incomes reduced. Even though this has

not yet happened to you, you may be worried that it will. As a result, you reduce

your buying of many products. As we shall see later, expectations are important

because they often become self-fulfilling prophecies.

7. The last of the factors affecting demand is the population (number of buyers) .

The market demand is simply the sum of the individual demands. If, at the price of

P10, Bill wants to buy 10 units of the product, Jose wants to buys 20 units, and Mary

wants to buy 30 units, then, of course, the market demand is 60 units. If Jordan

becomes a buyer and wishes to buy 40 units, the market demand rises to 100 units.

Therefore, if there are more buyers, there must be more market demand.

Let us summarize. The demand for a given product will rise if:

1. Incomes rise for a normal good or fall for an inferior good

2. The price of a complement falls

3. The price of a substitute rises

4. People like the product better

5. People expect the price to rise soon

6. People expect the product not to be available soon

7. People expect their incomes to rise in the near future



8. There are more buyers.

The opposite will cause the demand for the product to fall.

THE LAW OF SUPPLY

Thus far, we have been focusing exclusively on buyers. But buyers are only half of

the market. We must also consider the behaviors of sellers. Discussing sellers is

somewhat easier because we can assume that sellers have only one motivation: to

maximize their profits. Sellers will be motivated to do more of anything that increases

profits and less of anything that decreases profits. The profits are calculated as the

difference between the total revenues and the total costs.

Let us begin with the total revenues, the money taken in from selling our product. If we

sell 100 units at P10 each, our total revenues equal P1,000. If we sell 100 units at P20, our

revenues equal P2,000. Since we gain more revenues if the price is P20 than if it is P10, we

would likely want to sell more units of the product if the price is P20. So we can conclude

that as the price of the product rises (falls), the quantity supplied will rise (fall).

We call this statement the law of supply.

DETERMINANTS OF SUPPLY

There are four of them.

1. The goal of a company, once again, is to maximize profits, calculated as the difference

between the total revenues and the total costs of production. So, one of the

determinants of supply must be the costs of production. As costs of production

rise, profits fall, and therefore the quantity supplied should fall. Conversely,

as costs of production fall, the profits rise, and the quantity supplied should

rise. Costs include the costs of natural resources such as wood used in building a

home, the costs of labor (wages and benefits), and the costs of the capital. We will

cover them in later chapters.



2. When we considered demand, one of the determinants was population (the number of

buyers). The same is true for supply. One of the determinants of supply is the

number of sellers of the product . When the number of sellers increases, the

supply should increase. When the number of sellers falls, the supply should

decrease.

3. When we considered demand, one of the determinants was the price of a substitute

good. Again, the same is true for supply. In this case, the substitute is a substitute

for the seller --- another good also produced by the same seller . This may or

may not be a substitute for the buyer. For example, wheat and corn can be grown on

the same land; they are substitutes for the seller. So are avocados and oranges or

Coca Cola and Diet Coke (because they are produced by the same company). If the

price of the other good rises, the supply of the good in question will fall. For

example, if the good in question is wheat and the price of corn rises, sellers will

produce less wheat (and more corn). If the price of regular Coca Cola rises, the

supplier will produce less Diet Coke (and more regular Coca Cola). On the other hand,

if the price of the other good falls, the supply of this good will rise.

Remember that goods are substitutes for the seller only if they are produced by the

same company.

4. Finally, when we considered demand, one of the determinants was expectations .

This is true for supply as sellers also have expectations that affect their behavior. If

sellers expect the price to rise, they will want to sell less today. and wait for

the price to rise later. Home sellers will hold their homes off the market if they believe

the prices will rise soon. In 1973, oil tankers remained offshore while angry motorists

waited in long lines for gasoline.

The reason was that the price of gasoline was 36 cents per gallon. The government

was allowing the price to rise only 2 cents per week; the oil companies estimated that

it would rise to about 65 cents. So they reduced supply and waited until the price

would reach the predicted 65 cents. Conversely, if sellers expect the price to fall,

they want to sell more now. At the beginning of 1995, holders of Mexican pesos

believed that the price would fall. They got rid of them (sold them in the foreign

exchange market) as fast as they could. The same is true for holder of stocks in the

fall of 1998.



EQUILIBRIUM

Now, we can take the two sides of the market, demand and supply, and put them

together.

Price of market balance:

P - price

Q - quantity of good

S - supply

D - demand

P0 - price of market balance

A - surplus of demand - when P<P0

B - surplus of supply - when P>P0



Surplus a condition that exists when supply exceeds demand because of a lack of

equilibrium in a market. For example, if a price is artificially high, sellers will bring more

goods to the market than buyers will be willing to buy.

Shortage a condition that exists when demand exceeds supply because of a lack of

equilibrium in a market. If a price is artificially low, buyers want to buy more of a good than

sellers are willing to sell.

Equilibrium refers to a condition where a market price is established through competition

such that the amount of goods or services sought by buyers is equal to the amount of goods

or services produced by sellers. This price is often called the equilibrium price or market

clearing price and will tend not to change unless demand or supply change.

THE CIRCULAR FLOW OF ECONOMY

http://en.wikipedia.org/wiki/Market_clearing

http://en.wikipedia.org/wiki/Market_clearing

http://en.wikipedia.org/wiki/Equilibrium_price

http://en.wikipedia.org/wiki/Law_of_supply_and_demand

http://en.wikipedia.org/wiki/Law_of_supply_and_demand

http://www.answers.com/topic/dynamic-equilibrium



HOW ECONOMY WORKS?

Decision Makers:

1. Firms: (business sector)

Produce and sell goods and services/ Hire and use factors of production

2. Consumers: (Household sector)

Buy and consume goods and service/ Own and sell factors of production

Markets for Goods and Services



• Firms sell

• Households buy

Markets for Factors of Production

• Households sell

• Firms buy

The Household Sector is the owner of all of the Factors of Production w/c includes the ff:

Factors of Production:

1. Labor- brain power and muscle power resources

2. Land- natural resources of all kinds

3. Capital- all equipment, building, and tools

In return for the Factors of Production the Business Sector gives the Factors of Payment to

the h/s and it includes the ff:

Factors of Payment:

1. Wages – salary of Income paid by the business firms to workers

2. Rent – the reward that goes to the land resources

3. Interests- the cost of borrowing or the price paid for the rental of funds

4. Profit – the rewards of management or entrepreneur who take risks.

MARKET STRUCTURES

Remember that the goal of a company is to maximize its profits. Remember also that

profits are simply the difference between the total revenues and the total costs of



production. We examined the costs of production first because the principles affecting

costs are the same for all companies regardless of the industry they are in. But this is not

true about the revenues. To analyze the differences in total revenue, we group industries

into four types. They are classified according to the power a company would have to

affect the price of the product.

(A) Perfect Competition

There are four criteria for an industry to be characterized as perfect competition.

Of course, nothing is “perfect”. But, while no industry will exactly meet the four criteria of

perfect competition, we can learn much from assuming that such an industry does exist.

1. There are so many sellers that no one seller can affect the price by himself or

herself.

Think of yourself buying gasoline. The price says $2.00 per gallon. Suppose you ask

to see the manager and then make an offer: you will buy only if the price is reduced

to 50 cents per gallon. What will the manager do? The answer is: laugh and ask you

to leave. The manager will not take your offer because there are so many others

who will pay $2.00. These others are your competitors. You don't think of them as

competitors. Indeed, they may even be your friends. You think of them, like

yourself, as subject to impersonal market forces. But nonetheless, they are your

competitors. And because they are there, you have no influence at all on the price.

We say that you are a price taker. If we switch the example and make you a seller

instead of a buyer, we have the main characteristic of perfect competition. If a seller

charged more than $2.00 per gallon, no one would buy from him or her. The seller

would never charge less than $2.00 because there is no reason to do so.

2. We assume that all buyers and all sellers have perfect information.

Each knows what the price is, what others are charging, and all relevant features of

the product. No one would ever pay $3.00 for a gallon of gasoline because everyone

knows that there are sellers willing to charge $2.00.

3. We assume that there is easy entry into and exit from the industry.

Any company wanting to leave the industry can do so easily. And the are no barriers

preventing entry to any company from coming into the industry.



4. We assume that the products of the sellers in the industry are identical.

One company's product is just the same as another company's product.

Although there are no examples of perfect competition, agriculture is the closest. We will

start our analysis of business behaviors with this market structure.

(B) Pure Monopoly

Literally, "mono" means one. Therefore, a pure monopoly is an industry with only

one seller. Such a company should have considerable ability to affect the price that it

charges. However, for this to occur, two other characteristics are necessary. First, there

must be high barriers to entry. If this were not the case, then when the monopoly set a

high price and earned high economic profits, new sellers would enter to compete with it.

The increased competition would drive down prices, eliminating the economic profits that

were being earned. Second, the demand for the product needs to be relatively

inelastic (that is, has few substitutes). If this were not the case, then if the

monopolistic company raised its price, buyers would simply shift to other substitute

products. This would limit its ability to raise the price considerably. We will consider pure

monopoly after completing our analysis of perfect competition.

Monopoly vs. CARTEL: cartel refers to a market situation in which firm agree to cooperate

with one another to behave as if they were single firm and thus eliminate competitive

behavior among them.Cartel agree among themselves to restrict total output to the level

that maximizes their joint profit.

Example: Organization of Petroleum Exporting Countries (OPEC)

(C) Monopolistic Competition

If there is one seller but a very elastic demand for the product, the industry is

called monopolistic competition. The monopoly part results from there being one seller

of the narrowly defined product. The competition comes from other products that are

close substitutes. Most real-world competition takes this form. There is only one Coca-

Cola but there are many close substitutes. There is only one MacDonalds but there are



many close substitutes. There is only one iMac but there are many close substitutes. In

each case, the company can raise its price and not lose all of its sales. However,

an increase in price will cause it to lose a considerable portion of its sales. This

limits greatly the power of the company to affect the price. The first three characteristics of

perfect competition are similar for monopolistic competition. There are many sellers. The

buyers and sellers have perfect information. And there are no barriers to entry. The

difference is the fourth characteristic: in perfect competition, the products are

identical whereas in monopolistic competition, the products are differentiated.

Because products are differentiated, monopolistic competition involves considerable use of

advertising.

(D) Oligopoly

The final structure of an industry is called oligopoly. "Olig" means "few". In this industry,

there are few sellers. How few is "few"? The answer is "few enough that each

seller has an ability to affect the price". Usually most oligopolies are dominated by

between two and ten companies. Automobiles, steel, tires, cigarettes, accounting firms, and

breakfast cereals are among the many examples. Oligopolies are difficult to analyze

because each firm, in making a decision, must consider not only the response of the buyers

but also the response of the other sellers. Should Ford offer a rebate (lower price) on its

cars? The answer depends not only on the way buyers will respond to the rebate but also on

Ford's estimate of the response of General Motors, Chrysler, Honda, Toyota, and Nissan.

It would be easier to predict the responses of competitors if the competitors met and

discussed their decisions. Such a meeting of members of an oligopoly to coordinate

decisions (especially over the price) is known as a cartel. Cartels are illegal in the

United States; however, some have managed to exist. Examples are the National Collegiate

Athletic Association, Major League Baseball, the National Football League, etc. On a world

basis, there have been cartels in oil, diamonds, and other natural resources.

If we can imagine measuring market power (the ability to affect the price of the

product one sells) on a scale of zero to 100 (with 100 being the greatest amount of

power), the four market structures would be arranged as follows:

Perfect Monopolistic Pure

Competition Competition Oligopoly Cartel Monopoly



0________ _________________________________________________________100

Notice that pure monopoly does not have a market power of 100 on this imaginary scale.

Even if there were only one company, it cannot have total power over the price. Buyers

always have the power to not buy the product.

Benefits of Competition and Monopoly

1. Benefits To Society From Perfect Competition

Let us conclude the discussion of perfect competition by summarizing the benefits to society

from it. People believe that competition is good for the society as a whole. Why is this so?

Let us list some of these benefits.

(1) Economic Profit of Zero

As we saw, in perfect competition, companies earn an economic profit of zero in

the long-run. While the long-run is not specified in weeks or years, we can presume

it is a relatively short period. (The long-run is the time it takes for new companies to

enter the industry.) Why is this good for society? The answer is that, when

companies are earning economic profits above zero, new companies enter the

industry. The entry of the new companies will soon eliminate the economic profits.

The only way a company can earn economic profits for a long time period is

to be able to prevent other companies from producing products that

consumers desire. This clearly is not good for society. For many years,

companies like General Motors, IBM, and CBS earned economic profits that were well

above zero. They were able to maintain these profits only by having barriers to entry

that kept other companies from producing products that consumers definitely

desired.

(2) Productive Efficiency



Productive efficiency involves producing at the lowest possible cost of production.

In our example, the construction company chose to produce 7 homes. Each home

cost an average of $182,857 (take the total cost of building 7 homes and divide by

7). We can assume that this is the lowest possible cost per home of producing 7

homes. Companies in perfect competition have a financial incentive to

produce as efficiently as possible. Any inefficiencies are reflected in

reduced profits for the owners of the companies. Since in the long-run, these

profits equal zero, inefficiencies would cause economic profits to fall below zero.

Companies would either have to find more efficient ways of producing or be driven

out of business.

(3) Improvements over Time

As we have seen with so many products, companies with a large amount of

competition have a strong incentive to find new ways of producing that will

lower production costs. This strong incentive explains why products that were

once very expensive ---computers, VCRs, televisions, contact lenses, and so forth ---

are now so much cheaper. The incentive is actually twofold. On the one hand,

there is the positive reward of increased economic profits in the short-run if

a company can find a way of producing at a lower cost. On the other hand,

there is the fear that competitors of the company will find a way of

producing at a lower cost before it does. If they do so, they will be able to

charge a lower price. Our company will not be able to earn satisfactory profits at this

lower price. It risks being forced out of business.



Remember the definition of monopolistic competition. This industry structure has all of the

characteristics of perfect competition except that the products are differentiated. In that

case, we shall see that there are strong incentives not only to find ways to lower production

costs but also to find ways to "improve" the product. The incentives are the same in

both cases --- the increased economic profits in the short-run and the fear of a competitor

doing so first. What exactly is an "improvement"? The answer, in a market economy, is

that a product has been improved if consumers desire it more and are more likely

to buy it. Consumers decide when a given change in a product is actually an improvement.

The strong incentives to "improve" products are easily seen in the continual improving of

computer hardware and software, in the competition between the programs shown on

television stations, in competition in fashion design, in competition between automobile

companies, and in many other examples. To take just one example for illustration, let us

consider the coffee maker. Prior to 1970, people who drank coffee drank instant coffee, had

coffee brewed in a coffee percolator, or used a pyrex container. The pyrex container was

much cheaper than the percolator. One would heat water in the container, put the coffee

into a filter, put the filter into a plastic cone, and then pour the boiling water through the

cone back into the container. In the early 1970s, Vince Marotta decided to develop a

product that worked in the same way except that one poured cold water into a container

and a heater boiled the water. The boiling water then ran through the coffee that had been

placed in a plastic cone and into the pyrex container. He called this invention “Mr. Coffee”.

He advertised it heavily, with Joe DiMaggio as the spokesperson. It was a huge hit and

Marotta was soon making large economic profits. In a competitive industry, what should

happen? Of course, others should start producing similar products. And so they did. As the

supply rose, the economic profits fell. To maintain them, Marotta changed the design of the

container to allow “Brew for Two”. This too was a huge hit and economic profits rose.

Others, of course, soon copied. Then, Marotta combined his coffee maker with an alarm

clock. Now instead of making a sound, the alarm would turn on the coffee maker. Another

huge hit. Again it was soon copied. As time has gone one, we have seen space saver coffee

makers, coffee for one, designer coffee makers, and so on. Some products have been very

successful. Some have not. Since product improvements are easily copied by other

companies, eliminating the economic profits, why bother developing the improvements at

all? The answer, of course, is the economic profits in the short-run. Even if they don’t last

very long, the huge profits made for awhile were enough so that Mr. Marotta need have no

financial worries for the rest of his life.



In summary, in perfect competition in the long-run, companies will earn zero economic

profits, will produce that quantity for which cost per unit is the lowest possible (productive

efficiency), and will have strong incentives to find ways to lower costs of production and to

"improve" their products. No wonder people believe that a market economy with perfect

competition is so desirable.

2. Monopoly

We have examined perfect competition. Now we turn to its polar opposite: pure

monopoly. As noted, there are three main characteristics of pure monopoly. First, there is

only one seller of the product ("mono" means "one"). Second, there are few good

substitutes available for buyers. And third, there are high barriers to entry; if economic

profits are being earned, it will be very difficult for new sellers to enter the industry.

There are many reasons for the existence of high barriers to entry. For example, until

a few years ago, it was illegal to compete with San Diego Gas and Electric Co. (We will

examine the reasons for this later.) DeBeers has maintained its monopoly on diamond

production through control over the natural resource. Virtually all of the diamond in the

world has come into the control of this company, owned by the Oppenheimer family of South

Africa. IBM maintained close to a literal monopoly on mainframe computers through its

copyrighting of computer languages. Xerox and Polaroid maintained near monopolies by

patenting their processes. Automobiles had high barriers to entry because of the very

high costs of capital goods that were necessary. Some industries had high barriers to

entry because of government regulations. For example, until the early 1980s, the Civil

Aeronautics Board acted to prevent airlines from serving certain markets. And, until the

mid-1970s, the Federal Communications Commission acted to prevent access to the

airwaves to any new television network. In some industries, economies of scale make it

very difficult for new companies to enter. Because the existing larger companies can

produce at a lower cost per unit, a new company that starts with a small number of buyers

would not be able to compete on the basis of cost. We call these industries "natural

monopolies" and will discuss them in detail later. In some industries, vertical integration

can provide a barrier to entry. "Vertical integration" means that the same company

controls many phases of the production process. Companies that refine oil into



gasoline also own the oil wells and the tankers. They control the gasoline stations through

a franchise agreement. Any company trying to compete would have to find its own oil,

develop its own tankers for shipping, and create its own stations to sell the gasoline.

General Motors also was vertically integrated. General Motors owned the companies that

made automobile bodies, batteries and sparkplugs, glass, and so forth. And Microsoft

produces both computer operating systems and software programs. Is it any wonder that

the operating system Windows was made purposely incompatible with Lotus1-2-3, the most

popular spreadsheet in the world. (Microsoft produces a competing product --- Excel)

Finally, continual innovation can act as a barrier to entry. Both IBM and AT&T were able

to maintain near monopoly positions for many years by always being first with new ideas.

Microsoft has carried on in this manner. In the early 1980s, IBM lost its barrier to entry. The

hierarchical management of IBM was too slow to keep up with the need for innovation.

Other companies came up with new and better products, causing IBM to lose almost half of

its market share. Something similar occurred for AT&T.

The rice crisis is now a major concern that is highlighted daily on the front pages

of newspapers and on prime - time television. This paper explains the reasons

behind the rapid increase in rice prices and what must be done to achieve

reliable, plentiful supplies of affordable rice.

CONTENTS

What is happening?

What are the underlying reasons for the rice crisis?

How do price rises affect poor rice consumers?

How do we prevent shortages and price rises?

What needs to be done?

What is happening?

The poorest of the world’s poor are the 1.1 billion people with income of less than a dollar a

day. Around 700 million—almost two‐thirds—of these people live in rice‐growing countries of

Asia. Rice, the dominant staple in Asia, accounts for more than 40% of the calorie

consumption of most Asians. Poor people spend as much as 30–40% of their income on rice



alone. Ensuring sufficient supplies of rice that is affordable for the poor is thus crucial to

poverty reduction. Given this, the current sharp increase in rice price is a major cause for

concern. The Green Revolution in Asia, which began in the 1960s with the introduction of

modern, high‐yielding rice varieties, led to a rapid rise in both rice yields and overall

production. This contributed to poverty reduction directly through increased income for rice

farmers and indirectly through lower prices for rice, which benefited poor consumers in both

rural and urban areas.

However, this long‐term decline ended in 2001, with the rice price taking a sustained

upward turn since then. The price continued to rise throughout 2007 and has sharply

increased in the first quarter of 2008. The world price of Thai rice, 5%‐broken—a popular

export grade—in December 2007 was $362 per ton but almost tripled to $1,000 per ton in

April this year. Major exporting countries such as Vietnam and India have announced

different forms of export restrictions to protect their domestic consumers. These restrictions

have further contributed to the recent increase in rice price as the rice supply in the world

market has dwindled. While exporters are holding on to their stock of rice, importers are

rushing into the market to buy more rice to meet their consumption needs and to build their

own stock. Hoarding by traders for speculative purposes has added fuel to the fire in some

countries. The market shortages and rise in price have now reached a crisis point, with

recent quotes for rice price being as high as $1,000 per ton. Food riots have occurred in

several countries and soldiers are guarding food trucks to prevent looting.

What are the underlying reasons for the rice crisis?

We are consuming more than we are producing

Many factors, both long and short-term, have contributed to the rice crisis. At a fundamental

level, the sustained rise in the price over the past 7–8 years indicates that we have been

consuming more than we have been producing. This imbalance between demand and

production has been partly masked by a reduction in rice stockpiles. In fact, rice stocks are

being rapidly depleted, with current stocks at their lowest since 1988. This depletion of stock

has moderated the rise in price that would have occurred otherwise. The current low stocks,



however, negate the chances of such a moderating influence in the future and increase the

risk of a sharp rise in price.

Annual growth in yield is slowing

A major reason for the imbalance between the long‐term demand and supply is the slowing

growth in yield, which has decreased substantially over the past 10– 15 years in most

countries. In South Asia, average yield growth decreased from 2.14% per year in 1970‐90 to

1.40% per year in 1990‐2005. In some years, this has been below 1%. Yield growth in

Southeast Asia has decreased similarly. In the major rice‐growing countries of Asia, yield

growth over the past 5–6 years has been slow. Globally, yields have risen by less than 1%

per year in recent years.

Little room for expansion of rice area

Further, the possibility of increasing the rice area is almost exhausted in most Asian

countries. With little expansion in area and slowing yield increases, growth in rice production

has fallen below growth in demand as population has continued to increase.

Reduced public investment in agricultural research and development

An important factor accounting for the slowdown in yield growth is the reduced public

investment in agricultural research and development (R&D). In particular, international

donors have not provided sufficient support for agricultural R&D that is directly related to

increasing crop productivity. Many governments have been unable to compensate for this by

allocating more of their own resources.

Rice prices declined steadily in the 1990s, leading many governments to believe that the

supply of food was plentiful. Lower prices were taken for granted leading to complacency in

agricultural research and development. Such investment has decreased in Asia in real terms

over time. Public spending on agricultural research in Asia grew by an average of 3.9% per

year during the 1990s, compared with 4.3% annually during the previous decade. In 2000,

overall public research intensity, measured by the percentage of agricultural gross domestic

product (GDP) invested in public agricultural research, remained low at 0.53 for developing

countries as a whole.



Africa

Rice has become an increasingly popular food in Africa, with imports into Africa accounting

for almost one‐third of the total world trade in rice. This has increased over time as growth

in rice production is far slower than growth in total demand. It is expected that demand from

Africa will continue to grow.

Population increase

Population growth is outstripping production growth and this is projected to get worse.

Demand for rice in Asia is expected to continue to rise as its population expands. Even after

allowing for some decrease in per‐capita rice consumption in Asian countries with higher

income levels, it is projected that in 2015 Asia will need to produce 38 million more tons of

rough (unmilled) rice than it produced in 2005. Globally, demand is increasing by around 5

million tons each year. This means that in ten years the world will need to produce 50

million tons more than it does now.

Economic growth

With rapid economic growth in large countries such as India and China, demand for cereals

has increased substantially for both consumption and livestock production. This income‐

driven growth in demand has pushed up the price of cereals in general. In many areas with

high population density, highly productive rice land has been lost to housing and industrial

development, or to growing vegetables and other cash crops.

Irrigation

Investments in irrigation, which peaked during the Green Revolution period in the 1970s and

1980s, have decreased substantially. Existing irrigation infrastructure has deteriorated

considerably because of inadequate maintenance.

Oil prices



The price of oil has increased rapidly during the past year. In addition to contributing to

general inflationary pressure, this has pushed up freight costs for countries that import rice.

The world price of fertilizers—which are essential for rice production—has increased sharply,

with the price of urea almost doubling over the past four years. Rising oil prices and

concerns about climate change have also spurred rapid investments—particularly in

developed countries—in biofuels such as ethanol produced from maize grain or biodiesel

produced from oilseeds. This has increased pressure on international trade of grains and

livestock feed, as well as on agricultural land in some countries. Until now, the direct impact

of biofuels on rice production and rice trade has likely been small. However, if the industry

continues to grow, rice production and prices may be affected more seriously.

Extreme weather

Natural disasters such as widespread drought in India and China in 2002, typhoons in the

Philippines in 2006, and major flooding in Bangladesh in 2007 have contributed to the

shortfall in production in recent years. Global temperatures, particularly night‐time

temperatures, have steadily risen in recent decades because of increasing greenhouse gas

concentrations in the atmosphere. Some evidence suggests that rising temperatures may

have already contributed to lower rice yields in recent years, but a thorough global

assessment is yet to be conducted. Further, human‐induced climate change is expected to

increase the severity and frequency of extreme weather events.

Reoccurring pest outbreaks

Pests such as planthoppers, and the various virus diseases transmitted by them, were major

threats to rice intensification programs in the 1970s and 1980s. Now, they have returned as

major threats to production, primarily due to breakdowns in crop resistance and the

excessive use of broad‐spectrum, long‐residual insecticides that disrupt natural pest control

mechanisms.

Since 2005, planthopper outbreaks have affected several million hectares of rice land in

countries such as Vietnam, China, Indonesia, Korea, and Japan, particularly in growing

seasons with abnormally higher temperatures (which are becoming more likely because of

climate change). In Vietnam, planthopper and virus outbreaks were a major reason behind

the government’s decision to restrict rice exports.



How do price rises affect poor rice consumers?

Domestic rice prices have not risen as much as international prices because of the

weakening of the U.S. dollar and stabilization policies implemented by national

governments. Nevertheless, a rise in the price of rice is equivalent to a drop in real income

for poor consumers in urban areas and landless laborers in rural areas who need to buy rice.

Even a small increase in price can seriously affect the household food security of such

people. For example, a 25% increase in rice price translates into a 7–10% drop in the real

income of poor consumers, as rice purchases often constitute 30–40% of their total

expenditures.

Such a drop in income not only increases the number of poor people but also pushes people

deeper into poverty and hunger. With less money available, the poor are forced to spend

less on such essential needs as health care and nutritious (protein‐ and vitamin‐rich) food—

essential for good health, especially for children and pregnant women. Families may even

pull children out of schools, thus threatening future generations with ongoing poverty. The

rise in food prices is also affecting the poor indirectly as international relief agencies are

forced to provide less food. According to the United Nations Population Fund, its program of

school feeding and “food‐for‐work” is being severely affected as a result of the price rise.

The World Food Programme recently said that its costs are increasing by millions of dollars

per week.

How do we prevent shortages and price rises?

The best strategy for keeping the price of rice low is to ensure that production increases

faster than demand. Rice production can be increased by expanding the area planted to

rice, by increasing the yield per unit area, or by a combination of the two. The opportunity

for further increasing the rice area in Asia is now quite limited. The total rice area in Asia is

unlikely to increase much beyond the 10 current estimate of 136 million hectares. Although

some increase in cropping intensity is still possible, rice land is being lost to industrialization,

urbanization, or conversion to other crops. The main source of additional production will

therefore have to be yield growth. Global average rice yields must continue to rise at an



annual rate of at least 50 kg per hectare to keep pace with the expected demand, or by 0.5

tons per hectare over the next 10 years (about 12% above current levels).

Productivity growth through the development and dissemination of improved

technologies is the only long - term viable solution for bringing prices down,

preventing future increases in price, and ensuring that affordable rice is available

to poor rice consumers.

To achieve this, a second Green Revolution is needed now as much as the first Green

Revolution was needed to avoid famine and mass starvation. The task is equally challenging

but not insurmountable, provided a substantial boost is given to agricultural research, which

continues to remain highly underinvested. Increased research investment together with

policy reforms that make rice markets more efficient will help bring rice prices down to a

level affordable to the poor and, ultimately, reduce poverty.

What needs to be done?

In the near term, urgent actions from national governments and international agencies are

needed on two fronts: rapidly exploiting existing technological opportunities for increasing

rice yields and policy reforms to improve poor people’s food entitlements. Rice production

can be revitalized, but there are no silver bullets. The world community must invest now and

for a long time to come. Some of the actions listed below deal with the immediate crisis

while others provide long‐term solutions to prevent future crises. IRRI is calling for the

implementation of the following nine‐point program of short‐ and long‐term interventions:

1. Bring about an agronomic revolution in Asian rice production to reduce existing

yield gaps

Farmers have struggled to maximize the production potential of the rice varieties they are

growing, so there is a gap between potential yield and actual yield. Depending on

production conditions, an unexploited yield gap of 1–2 tons per hectare currently exists in

most farmers’ fields in ricegrowing



areas of Asia. Such yield gaps can be reduced through the use of better crop management

practices, particularly in irrigated environments. This requires funding support for programs

aimed at improving farmers’ skills in such practices as land preparation, water and nutrient

management, and control of pests and diseases.

2. Accelerate the delivery of new postharvest technologies to reduce losses

Postharvest includes the storing, drying, and processing of rice. Most farmers in Asia suffer

considerable losses in terms of both quantity and quality of rice during postharvest

operations because of the use of old and inefficient practices. Active promotion of exciting

new technologies that are currently available for on‐farm storage and drying will reduce

losses considerably.

3. Accelerate the introduction and adoption of higher yielding rice varieties

New rice varieties exist that could increase production, but farmers are not using them

mainly because the systems that develop and introduce new varieties are under‐resourced.

4. Strengthen and upgrade the rice breeding and research pipelines

Funding for the development of new rice varieties has steadily declined over the past

decade or more. This must be reversed in order to develop the new rice varieties that will be

required for sustained productivity growth. Opportunities exist to accelerate the

development of new rice varieties with increased tolerance of abiotic stresses (such as

drought, flooding, and salinity) and resistance to insects and diseases through new

precision‐breeding approaches. Likewise, record high fertilizer prices and

new pest outbreaks demand the urgent revitalization of research on rice crop and resource

management.

5. Accelerate research on the world’s thousands of rice varieties so scientists can

tap the vast reservoir of untapped knowledge they contain

Working with IRRI, the nations of Asia have spent decades carefully collecting the region’s

thousands of rice varieties. More than 100,000 types of rice are now being carefully

managed and used at IRRI and in Asian nations. However, scientists have studied in detail

only about 10% of these types. It is urgent that researchers learn more about the other 90%

so they can be used in the development of new varieties.



6. Develop a new generation of rice scientists and researchers for the public and

private sectors

Another vital concern for the Asian rice industry is the education and training of young

scientists and researchers from rice‐producing countries. Asia urgently needs to train a new

generation of rice scientists and researchers—before the present generation retires—if the

region’s rice industry is to successfully capitalize on advances in modern science.

7. Increase public investment in agricultural infrastructure

Adequate investments in agricultural infrastructure such as roads, irrigation systems, and

market systems are critically important for raising and sustaining productivity growth in rice.

As with agricultural research, the underinvestment in infrastructure needs to be corrected

urgently.

8. Reform policy to improve the efficiency of marketing systems for both inputs

and outputs

Domestic and international marketing systems need to improve so that changes in

consumer prices are reflected in producer or farm‐gate prices (this is known as efficient

transmission of price signals). Policies should be developed and revised to remove barriers

to the efficient transmission of price signals and to create conditions that allow the private

sector to function smoothly.

9. Strengthen food safety nets for the poor

Poor and disadvantaged people who are highly vulnerable to food shortages require strong

food and social safety net programs to ensure that their needs are adequately met. Both

urban and rural poor people would benefit from food or income transfers and nutrition

programs focusing on early childhood.

*Suggested citation

IRRI (International Rice Research Institute). 2008. Background Paper: The rice

crisis: What

needs to be done? Los Baños (Philippines): IRRI. 12 p. www.irri.org.

Nature of Economics

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