Introduction to Economics

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SLMtitle.png Understanding Economics and Microeconomics

SLMobj.png Learning Objectives
After reading this chapter, you are expected to learn about:
  • Understand the meaning and scope of the subject Economics
  • Understand the meaning of and the disctinction between the terms Microeconomics and Macroeconomics
  • Understand the subject matter of Microeconomics
  • Understand the importance and significance of Microeconomics
  • Understand the limitations of Microeconomics

SLMinto.png Introduction

What is Economics?

In your daily life you must have experienced that as a human being you hold many desires and requirements but the means to satisy them are limited. For example let us assume that you are a student of an undergraduate programme and as you are still studying, you don't have any regular source of income except for the monthly pocket money of Rs. 750 which your parents are giving to you every month. This pocket money is the only monetary source for you to take care of your monthly expenses. Thus, we can say that you have limited monetary resource of Rs. 750 per month to satisfy your various desires and requirements. Let us further assume that your various desires and requirements are follows:

  • You want to see the latest movie which has been declared a box office hit
  • You want to buy a new car similar to one which your friend owns and uses * You want to purchase mobile phone cum tablet which has been recently launched by XYZ company in the market
  • You want to eat out with your friends in good restaurant located near your college
  • You need to buy certain course books as you semester end examinations are near
  • You have to spend on taking print out of the six class assignments which are due for submission to the college by end of this month.

In nutshell your desires and requirements are many and your means are limited (Rs. 750 that you get every month as pocket money). In such a case you will have to prioritize your desires and requirements on the basis of their importance and gain associated with them. In other words, you will be able to satisfy only some of your desires and requirements and not all given your limited means or resources. Thus in above example you might be position to satisfy only following desires and requirements:

  • Buying course books for the examination preparation
  • Paying for taking print out of the six class assignments due for submission
  • And either seeing the movie released recently or eating out with your friends.

This action of yours through which you allocated your limited resource (pocket money of Rs. 750 per month) in order to satisfy your various desires and requirements in order to ensure maximization of your gain or return is the crux of the subject Economics.

Economics is thus a social science which studies human behaviour when an individual is encountered with unlimited desires but holds limited means to satisfy them. Economics studies that how individuals (i.e; an Individual human being or an individual firm or an Industry etc) optimise their resources to maximize their gains.

To quote words of famous economists, following are few well accepted definitions of Economics:

  • In words of Alfred Marshall, "Economics is the study of people in the ordinary business of life"
  • In words of Lionel Robbins "Economics is the science which studies human behaviour as a relationship between given ends and scarce means which have alternative uses"
  • In words of Paul A. Samuelson "Economics is the study of how socities use scarce resources to produce valuable commodities and distribute them among different people"

Economics is thus a social science which studies following:

  1. How an individual uses his limited resources to maximise his well being
  2. How companies use their limited resources to maximise their business gains and profit
  3. How an Industry uses the limited resources in order to maximize gains of the individual firms which are part of the Industry as a whole
  4. How society at large uses the limited resources at its disposal in order to produce required goods or commodities and distribute them among various individuals in society.

Various aspects of economic theory include: study of Production and factors of production like Land , Labor, Capital and Organization, study of Consumption, study of Money, Income, Investment, Distribution etc.

Micro and Macro Economics

As the terms imply, Microeconomics focuses on micro or small segment of economy and thus Microeconomics studies decision making process and econtomic problems of individuals ( household, firm, industry etc) with respect to their usage of scarce means or resources for satisfying their unlimted ends. On the other hand Macroeconomics looks at a larger picture and is thus the study of economy as a whole.

In order to understand the concepts better, we can say that Micro Economics is the study of an individual human being, an individual household, an individual firm or an individual industry etc with respect to how they use given scarce means among their alternative uses in order to maximize their gain or return as a whole. Thus, Micro Economics does not study the economy as a whole and instead studies individuals and their gain maximizing behaviour in the economy. Micro Economics studies and analyzes individual (human being, household, firm, industry etc)behaviour with respect to production, consumption, distribution, price determination etc.

Macroeconomics on the other hand studies the aggregate economic behaviour of households, firms, industries etc in the economy as a whole.It focuses on broader economic issues like business cycles, inlation, deflation, stagflation, issues related to economic growth and development,national income, employment, money and monetary policy, fiscal policy etc.

Understanding the difference between Micro and Macro Economics

  • Microeconomics studies the economic behavior of an individual firm, industry, household, consumers etc in an economy. On the other hand, Macroeconomics studies the economic behavior of firms, industries, household consumers etc at an aggregate level or we can also say that Macroeconomics is the study of entire economy or economic systems.
  • Microeconomics studies issues like demand, supply, production, production efficiency, cost, cost minimization, market structure, pricing, distribution, profit maximization etc at the individual firm, industry, household, consumer level etc. On the other hand, Macroeconomics studies economic issues and problems affecting economy at a broader level. These issues can inflation, deflation, business cycles, problem of economic growth, national income, employment etc.
  • Macroeconomics explains and deals with the economic environment which individuals firms, industry, household etc face or encounter and the issues in economic environment impact the decision making of individual firms, industry, households etc however these individual entities do not hold any power to control or to manage the macroeconomic issues at an individual level.

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Case Study
Understanding differance between Micro and Macroeconomics

  • Case 1: Let us assume that your mother is managing various household expenses and requirements with the limited resources she holds. Let us further assume that this limited resource is the salary of your father earned on monthly basis. Your mother, thus every month, undertakes budgeting or allocation of resource exercise in order meet various household requirement with the limited means she holds in such a way that such allocation of resources leads to maximisation of benefits/gain for the individual household. This is crux of the subject Microeconomics. Let us further assume, that in the economic system problem of 'Inflation' emerges and this leads to creation of disturbance in the monthly household budget of your mother. Your mother cannot impact or control the inflation as inflation is a macroeconomic problem. What she can do is to use microeconomic theory of production, cost, pricing etc in order to ensure that she is still in position to meet same household expenses with the nominal per capita income of your father even if his real income has declined.

In this case the resource allcation exercise which your mother undertakes is microeconomics while the problem of Inflation is a Macroeconomic issue.

  • Case 2: Most of the clients/cudstomers of Infosys (a very successful Indian information technology company) are located in overseas market. Infosys provides them with its on-sight as well as off-sight service and support. Infosys, over the last few years has been successful in managing its resources (primarily talented human resource of Infosys) in such a way so as to maximize the gains the for the company. This micromanagement of resources at Infosys for the profit and gain maximization is microeconomics.As most the clients of Infosys at located overseas and thus maximum earnings of the company are denominated in terms of UD Dollars, Euros etc. The excahnge rate movement of US Dollar (USD), Euro etc is a macroeconomic issue and is dependent oneconomic factors like Inflation, GDP growth rate, Interest rates etc and thus is beyond the capability of Infosys to control or manage them. However, any change in the value of USD or Euro vis-a vis Indian rupee impacts earnings of Infosys. In this case Infosys can use various hedging techniques at the company level in order to minimize its foreign excahnge risk.

In this case the issue of allocation and management of resources at the disposal of Infosys for maxisimising the gains for the company is a Microeconomic issue while issue of fluctation in the value of USD, Euro etc is a macroeconomic issue and is beyond the control of the company.

Scope of Microeconomics

Microeconomic theory deals with four important issues at an individual level. These issues are:

  • What should be produced?
  • How much it should be produced?
  • How can one make best use of given resources while producing goods and services in order to maximize the efficiency of production and consumption or to maximize the returns for an individual (fir, industry, household etc)?
  • How the goods and services can be distributed for maximum well being?

The scope and subject matter of Microeconomics covers following three aspects:

  • Theory of Firm and Product Pricing
  • Theory of Factor Pricing (As per economic theory there are four factors of Production – Land, Labour, Capital and Organization)
  • Welfare Economics

The theory of 'Firm and Product Pricing' analyses and discusses following topics:

  • Theory of Demand and Supply
  • Theory of Production
  • Theory of Cost
  • Theory of Markets - Perfect markets and Imperfect Markets like Monopoly, Duopoly, Oligopoly, Monopolistic competition
  • Theory of Product Pricing in various market situations

In brief, the theory of Firm and Product pricing discusses demand and supply environment encountered by individual firms, industries etc. It discusses how given resources can be allocated for production in order to ensure maximization of profit/minimization of cost. It also discusses various market situations possible and determination of product price under various market situations.

The theory of 'Factor Pricing' analyses and discusses following:

  • Labor theory and theory of Wage
  • Theory of Rent
  • Theory of Interest and
  • Theory of Profit

In brief, the Factor pricing theory discusses how the reward or return for the various factors of production (Land, Labor, Capital and Organization) can be decided when they are contributing to production activities.

The 'Welfare theory' discusses the following:

  • Criteria of Social Welfare
  • Maximization of Social Welfare
  • Determination of Welfare optimizing output mix, commodity distribution and resource allocation

In brief, Welfare theory discusses and understand the criteria of 'Social Welfare' and how the same can be achieved in an economy. It also discusses the determination of welfare maximizing output-mix, commodity distribution and resource allocation.

Importance and Significance of Microeconomics

The study of Microeconomic theory helps in following:

  • Understanding operation of economy at a micro level - The study of Microeconomics helps us in understanding various market situations which are possible in any economy. It helps in understanding the economic reasons behind the decisions like – What to Produce? For whom to produce? How much to Produce? etc.
  • Optimization of resource allocation - The study of Microeconomics leads to understanding that how a firm or an industry etc can maximize their production efficiency and profit of a firmor the industry.
  • Minimization of Cost - The study of Microeconomics helps on the determination of optimum production point for a firm/industry.The theory also helps in determining the point of cost minimization for a firm
  • Understanding Consumer Behaviour - The study of Marginal Utility theory, Revealed Preference Hypothesis, Consumer Indifferance curves etc help in understanding and predicting the consumer behaviour
  • Demand Forecasting - The theory of Demand and Demand analysis, theory of elasticity of demand etc help in understanding and forecasting demand of a product.
  • Impact of change in Price/Income/Prices of related goods etc on the demand of a Product - The study of Microeconomic theory can help an individual firm to understand the impact of change in price, income, prices of related goods etc on the demand of a good under consideration.
  • Government Policy Making - The study of demand theory, supply theory, market theory can help the government in policy making at macro level. For example the study of microeconomic theory can help in deciding appropriate tax policy, pricing policy of the public goods and services, impact of tax policy in reducing inequality of income and wealth etc
  • Foreign trade and exchange rate determination - Microeconomic theory of Demand, supply, elasticity of demand etc help in understanding the impact of change in tarrif terms on the terms of trade. Similarly microeconomic theory of demand,supply etc helps in understanding exchange rate determination process in the foreign exchange market.
  • Maximisation of Social Welfare - The study of Microeconomic theory can help in deciding the appropriate allocation of resources, commodities and output mix for the maximization of the social welfare.
Limitations of Microeconomics

The study of Microeconomics gives us useful insight into operational aspects of an economy at the micro or individual level. As discussed above, the study of Microeconomic theory can help us in deciding upon the best resource allocation process for the maximisation of social welfare. The study of Microeconomic theory also helps in demand forecasting, deciding the economic policies of the government, price determination under various market situations etc. However there are certain shortcomings of the Microeconomic theory as well. We need to understand these limitation in order to complete our understanding of the Microeconomic theory.

The limitations of Microeconomics are as follows:

  • Microeconomic theory assumes full employment in an economy. This assumption is unrealistic in the real markets. No economy or economic system in the world has witnessed or experienced the full employment scenario till date.
  • Microeconomic theory assumes of a 'Lassiez Faire' economic system. This means an economic system having 'No government intenvention'. However, when we look around us, we realize that all economic systems across the world including the capitalist economies experience government intervention into the economic systems on a very regular basis.
  • Most Microeconomic theories are based on the static assumption of 'Ceteris Paribus' which means 'Other things being equal'. Again, this assumption of ceteris paribus, is unrealistic in the real markets.
  • Microeconomic theory sometimes leads to generalization of individual behaviour and this may not always be true or correct.
  • Microeconomics is only a part study of a economy and thus it does not help us much in understanding any economic system as a whole.

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See also