CHAPTER 3

THREE FUNDAMENTAL LAWS OF ECONOMICS

To satisfy our wants to the utmost with least effort – to procure the greatest amount of what is desirable at
the expense of the least that is undesirable – in other words, to maximize pleasure, is the problem of
economics. (UTILITY)
W. Stanley Jevons

…The state of the art being given, doubling the labor does not double the produce. (DIMINISHING
RETURNS)
John Stuart Mill

Jack of all trades and master of none. (COMPARATIVE ADVANTAGE)

Anonymous

Introduction
Understanding economics is greatly facilitated by the existence of economic laws. They explain the
regularity of the behavior of economic agents as well as predict the outcome of economic choices or
decisions.

THREE FUNDAMENTAL LAWS OF ECONOMICS

1. Consumption: LAW OF DIMINISHING MARGINAL UTILITY – A law governing satisfaction derived from
the consumption of goods. This law is the cornerstone of the theory of demand.
- The satisfaction of human wants is largely a psychological phenomenon.
- The benefit or utility that is derived from the consumption of a good depends on individual
experience.
o i.e., if you love eating mangoes and you are to eat as many mangoes as you like on a given
day, this law simply says that there is a point in that eating experience when the last mango
does not give as much pleasure as the earlier one.
- The law of diminishing marginal utility states that the consumption of a good yield increasing
satisfaction (utility) to the consumer, but the additional satisfaction received becomes less as more
of the good is consumed.
- Because the consumer fits the budget according to the prices of the goods, the law of diminishing
marginal utility plays the important role of determining how the consumer distributes the
purchases made. In this sense, the consumer optimizes the total satisfaction derived from all the
purchases of goods. To be able to optimize consumption, efforts are exerted to maximize the total
amount of satisfaction derived from all the consumption of goods that one buys in accordance with
one’s budget.
o The consumer tries to maximize total utility, not marginal utility.

2. Production: LAW OF DIMINISHING RETURNS – This law describes the behavior of production as inputs
are added. It is basic to an understanding of the theory of supply.
- For instance, one could think of a two-hectare palay farm. The output of palay would increase as
the number of man-years of labor are added (man-month, man-day, man-years are sometimes
used as standard measures of labor).

Course Outline in Applied Economics(source: Economics by GERARDO P. SICAT new edition) prepared by C.Ocfemia-Instructor @ SanJoseNHS-SeniorHigh
 - What can be expected is that as more units of labor are added, the output will increase. There may
be a stage in the productive effort in which the rise in output will be very high. Eventually, the rise
of outputs as more labor is added begins to taper off.
- Statement about this technical relationship may be set in terms of the production function. This
may be formally written as a relationship of output with the factors of production.

3. THE LAW OF COMPARATIVE ADVANTAGE – This law concerns efficiency in production. It is the
foundation of the law of gains from commerce, both international and domestic.

Comparative vs absolute advantage

- Absolute advantage can be defined as superior ability compared to others in producing a
commodity or in performing specific tasks.
- Since people face limitations in terms of time and resources, they are often forced to concentrate
their time and effort in what they consider the most efficient use of their time.
- A person may have absolute advantage over another person, but if he is to maximize his ability to
perform in an occupation, he would pick the activity that he has a comparative advantage in and let
others take on the other activity.
o For an example, let us take Peter who is a medical doctor and also an excellent driver and
mechanic. However, although Pedro is not as good a driver-mechanic as he is, he hires the
latter so he can concentrate on his medical practice. This setup also allows Pedro to earn a
living as driver and mechanic.
- Comparative advantage is a powerful explanation for the reasons why people are engaged in their
occupations and why certain regions and countries experience economic progress.

These three fundamental economic laws are linked together.

- The law of diminishing marginal utility is important to the understanding of demand. In general, a
consumer would buy more of a good at a low price than at a high price.
- The law of diminishing returns arises from the technological and physical behavior of the
production process when a factor of production increases while other factors are held constant.
The law of diminishing returns is a natural outcome of technology in operation.
- The law of comparative advantage provides an explanation for the efficiency of production across
the range of goods that are produced and traded.

Course Outline in Applied Economics(source: Economics by GERARDO P. SICAT new edition) prepared by C.Ocfemia-Instructor @ SanJoseNHS-SeniorHigh