Unit 1: Introduction to Microeconomics
Meaning, Nature, Scope, Importance, and Limitations of Micro Economics
Meaning of Microeconomics
The term "Microeconomics" is derived from the Greek word "mikros," meaning "small." Microeconomics is the branch of economics that studies the behavior of individual economic units. These units include individual consumers, households, firms, or specific industries.
It focuses on how these individual units make decisions regarding the allocation of scarce resources and how their interactions determine the prices and quantities of goods and services. For this reason, microeconomics is also often called Price Theory.
Nature of Microeconomics
- Individualistic Study: It doesn't study the economy as a whole (that's macroeconomics). It 'zooms in' on the individual parts.
- Based on Assumptions: Microeconomics relies heavily on assumptions to simplify complex reality. The most common assumption is "ceteris paribus," which means "all other things being equal."
- Price Determination: Its central focus is determining the prices of goods (in the product market) and factors of production like land, labor, and capital (in the factor market).
- Partial Equilibrium: It generally uses partial equilibrium analysis, which studies the equilibrium of one market or unit in isolation, assuming other markets are unchanged.
Scope of Microeconomics
The scope of microeconomics is wide and covers the following key areas:
- Theory of Demand: Analyzes consumer behavior, how they choose goods, and how factors like price and income affect their choices (utility analysis, indifference curve).
- Theory of Production and Cost: Studies how firms combine resources (inputs) to produce goods (outputs) efficiently and how their costs behave (production functions, cost curves).
- Theory of Product Pricing (Price Determination): Explains how prices are set in different market structures, such as perfect competition, monopoly, and monopolistic competition.
- Theory of Factor Pricing: Determines the prices paid for factors of production. This includes the determination of wages (for labor), rent (for land), interest (for capital), and profit (for entrepreneurship).
- Welfare Economics: Deals with economic efficiency and social welfare. It assesses how well an economy allocates resources to maximize overall societal well-being.
Importance of Microeconomics
- Understanding the Economy: It helps understand how our market-based economy functions.
- Price Determination: Explains how the prices of millions of goods and services are determined.
- Business Decision-Making: Firms use microeconomic principles to make decisions on pricing, production levels, costs, and investment.
- Resource Allocation: It shows how scarce resources are efficiently allocated among competing uses.
- Basis for Public Policy: Governments use it to formulate policies like taxes, subsidies, price controls (e.g., minimum wage), and trade policies.
Limitations of Microeconomics
- Unrealistic Assumptions: Many models assume perfect competition, full employment, and perfect information, which are rare in the real world.
- Fallacy of Composition: It assumes that what is true for an individual part is also true for the whole. For example, saving more may be good for one person, but if everyone saves more, it can lead to a recession (this is the "paradox of thrift").
- Ignores Macro Issues: It cannot explain economy-wide problems like inflation, unemployment, or economic growth.
Basic Problem of Economics, Problem of Scarcity and Choice
The Basic Problem of Economics
The basic problem of economics, also known as the central economic problem, arises because of two fundamental facts of life:
- Human wants are unlimited: People always desire more goods and services. Once one want is satisfied, another emerges.
- Resources are scarce: The resources (or factors of production) needed to produce goods and services—land, labor, capital, and entrepreneurship—are limited in supply.
Problem of Scarcity and Choice
This conflict between unlimited wants and scarce resources is the problem of scarcity. Because resources are scarce, we cannot have everything we want. This forces every society, rich or poor, to make choices.
This problem of choice leads to three basic economic questions:
- 1. What to produce?
Since resources are scarce, a society cannot produce everything. It must decide which goods and services to produce and in what quantities. For example, should it produce more consumer goods (like cars and smartphones) or more capital goods (like machinery and factories)?
- 2. How to produce?
This question concerns the choice of production techniques. Should goods be produced using labor-intensive methods (more workers) or capital-intensive methods (more machines)? The choice depends on the availability and cost of labor and capital.
- 3. For whom to produce?
This is the problem of distribution. How will the total output of goods and services be divided among the members of society? Should it be based on income, wealth, or need?
Opportunity Cost, Production Possibility Frontier
Opportunity Cost
Opportunity Cost: The value of the next-best alternative forgone when a choice is made.
Example: If you have $20 and you choose to buy a book, you cannot use that same $20 to buy dinner. The opportunity cost of buying the book is the dinner you had to give up.
This is the true economic cost of any decision. It exists because of scarcity and the need to make choices.
Production Possibility Frontier (PPF)
The PPF (also called Production Possibility Curve or PPC) is a graph that illustrates the concepts of scarcity, choice, and opportunity cost.
- Definition: The PPF is a curve that shows the various combinations of two goods that an economy can produce efficiently with its given resources and technology.
- Key Concepts Illustrated by the PPF:
- Scarcity: Represented by the boundary itself. Combinations outside the curve (like point Z) are unattainable.
- Choice: Society must choose one point on the curve (like A, B, or C).
- Efficiency: Any point on the curve (A, B, C) represents full and efficient use of resources. Any point inside the curve (like point X) is inefficient (e.g., unemployment or underutilization of resources).
- Opportunity Cost: The slope of the PPF measures the opportunity cost of producing one more unit of the good on the x-axis.
- Increasing Opportunity Cost: The PPF is typically concave (bowed-out) from the origin. This shape reflects the law of increasing opportunity cost: as you produce more of one good, you must give up increasingly larger amounts of the other good. This is because resources are not equally suited to producing all goods.
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Economic Systems
An economic system is the method a society uses to organize its economy to answer the three basic economic questions (What, How, and For Whom to produce?).
| Feature |
Capitalism (Market Economy) |
Socialism (Command Economy) |
Mixed Economy |
| Ownership of Resources |
Primarily private individuals and firms. |
Primarily the state (government). |
Co-existence of private and public sectors. |
| Decision Making |
Done by individual buyers and sellers via the price mechanism (market forces). |
Done by a central planning authority (government). |
Done by both market forces and government planning/regulation. |
| Main Motive |
Profit maximization and individual self-interest. |
Social welfare and collective goals. |
Both profit maximization and social welfare. |
| Examples |
USA, UK (though most are technically mixed). |
Former USSR, North Korea, Cuba. |
India, France, Sweden, most modern economies. |
Positive and Normative Economics
Economics can be divided into two types of analysis based on its purpose: positive and normative.
Positive Economics
- Definition: It describes and explains economic phenomena as they are. It deals with facts, data, and causal relationships.
- Nature: It is objective and focuses on "what is."
- Testability: Statements can be tested, verified, or refuted by checking them against real-world data.
- Keywords: "is," "was," "will be," "causes."
- Example: "An increase in the price of petrol will lead to a decrease in the quantity demanded of cars." (This is a testable hypothesis).
Normative Economics
- Definition: It makes recommendations or value judgments about what the economy ought to be or what policy should be pursued.
- Nature: It is subjective and focuses on "what should be."
- Testability: Statements are based on opinions, values, and ethics. They cannot be scientifically tested or proven true or false.
- Keywords: "should," "ought to," "fair," "unfair," "good," "bad."
- Example: "The government should provide free healthcare to all citizens." (This is a value judgment, not a testable fact).
Exam Tip: A common question is to identify whether a statement is positive or normative. Look for facts (positive) vs. opinions or recommendations (normative).
Market Forces
The Law of Demand
The Law of Demand states that, ceteris paribus (all other factors being equal), as the price of a good increases, the quantity demanded for that good decreases, and vice versa.
This shows an inverse relationship between price and quantity demanded, which is why the demand curve slopes downwards from left to right.
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Determinants of Demand (Factors that Shift the Demand Curve)
A change in price causes a movement along the demand curve. A change in any other determinant causes a shift of the entire curve (Increase = shift right; Decrease = shift left).
- Income of the Consumer: (Normal goods: Income up → Demand up; Inferior goods: Income up → Demand down).
- Prices of Related Goods: (Substitutes: Price of Coke up → Demand for Pepsi up; Complements: Price of Car up → Demand for Petrol down).
- Tastes and Preferences: If a good becomes more fashionable, its demand increases.
- Future Expectations: If you expect the price to rise in the future, your demand today will increase.
- Number of Buyers (Market Size): More buyers lead to higher market demand.
The Law of Supply
The Law of Supply states that, ceteris paribus, as the price of a good increases, the quantity supplied of that good also increases, and vice versa.
This shows a direct relationship between price and quantity supplied, which is why the supply curve slopes upwards from left to right. (Higher prices give producers a greater incentive to produce more).
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Determinants of Supply (Factors that Shift the Supply Curve)
A change in price causes a movement along the supply curve. A change in any other determinant causes a shift of the entire curve (Increase = shift right; Decrease = shift left).
- Input Prices (Cost of Production): Cost of raw materials or labor increases → Supply decreases (shifts left).