Introduction to Economics and Microeconomic Theory
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MICROECONOMICS
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Introduction to Economics and Microeconomics |
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Learning Objectives |
After reading this chapter, you are expected to learn about:
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Understanding Economic Theory |
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 the 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 the gains associated with them. In other words, you will be able to satisfy only some of your desires and requirements and not all as you have limited means or resources. Thus in above example you might be position to satisfy only following few 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 while ensuring 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:
- How an individual uses his limited resources to maximise his well being
- How companies use their limited resources to maximise their business gains and profit
- How an Industry uses the limited resources in order to maximize gains of the firms which are part of the Industry as well as the Industry as a whole
- 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 study and analyze thefollowing: Production and factors of production (Land , Labor, Capital and Organization), Cost, Factors impacting Demand and Supply, Demand and Supply analysis, Pricing under various market situations, Factor Pricing, Welfare analysis, Consumption, Money, National Income, Investment, Distribution, Problem of economic growth and development etc.
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Micro and Macro Economics |
Microeconomics and Macroeconomics
As the terms imply, Microeconomics focuses on micro or small segment of economy and it studies the decision making process and econtomic problems of individuals ( household, firm, industry etc) in an economy with respect to that how they use scarce means or resources at their disposal for satisfying their unlimted ends. On the other hand Macroeconomics looks at a larger picture and is study of economy as a whole.
In order to understand the concepts (Microeconomics and Macroeconomics) better, we can say that Microeconomics 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/divide their given scarce means among the possible alternative uses/ends in order to maximize their gain or well being. Microeconomic theory does not study the economy as a whole and instead studies the individuals and their gain maximizing behaviour in any economy. Microeconomics studies and analyzes individual (human being, household, firm, industry etc) behaviour with respect to issues like production, consumption, distribution, price determination etc.
Macroeconomics on the other hand, studies the aggregate or overall economic behaviour of households, firms, industries etc in any economy.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. In other words, we can say that Macroeconomics is the study of economy or economic systems as a whole.
- Microeconomics studies issues like demand, supply, production, production efficiency, cost, cost minimization, market structures, pricing, distribution, profit maximization etc at the individual firm, industry, household or at consumer level. On the other hand, Macroeconomics studies the economic issues and problems affecting economy at a broader level. These issues can be problem of inflation, deflation, stagflation, business cycles, problem of economic growth, national income, employment etc.
- Macroeconomic theory explains and deals with the economic environment which an individuals firms, industry, household etc face or encounter. Such issues (inflation, deflation, business cycles etc) in the economic environment impact the decision making of the individual firms, industry, households etc. However, these individual entities (focus of Microeconomic theory is on economic behaviour of individual entities) do not hold any power to control or to manage the macroeconomic issues at an individual level.
| Understanding differance between Micro and Macroeconomics |
Case 1
Let us assume that your mother is managing various household expenses and requirements with the limited monetary resource she holds. Let us further assume that this limited resource is the income 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 that she holds in such a way, that such allocation of resources leads to maximisation of benefits or gains for the individual household. This is crux of the subject Microeconomics.
Let us further assume that in the country where you are residing, the problem of Inflation (Inflation is an economic problem in which an economy experiences continous and persistent rise in prices of goods and services being sold in the economy) emerges and this disturbs the monthly household budget of your mother. Your mother cannot control or manage the problem of inflation as inflation is a macroeconomic issue. Thus, in order to deal the impact of inflation on her household budget, your mother will have to reallocate her limited monetary resource among various goods and services which she is currently buying. This reallocation of resource exercise will most likely result in substitution of expensive goods and services with the cheaper alternative options available in the market. Your mother will be forced to do so because any increase in prices of goods and services in any economy shrinks the real income of the individuals in the economy. This is on account of the fall in the value of money and thus real income due to continous and persistent rise in prices
In this case the resource allcation exercise which your mother undertakes is subject matter microeconomic theory while the problem of Inflation is part of study of Macroeconomic theory.
Case 2
Most of the clients or customers of Infosys Technologies(a very successful Indian Information Technology firm) are located in the overseas markets like USA, Europe, Latin America etc. Infosys provides its clients with on-sight as well as off-sight IT service and support. Infosys Technologies, over the last few years, has been successful in managing its resources (primarily talented human resource) in such a way so as to maximize the return/profit of the company. The management of resources at the Infosys Technologies among various requirements/enf for the profit maximization is focus of microeconomic theory.
As already discussed, most of the clients of Infosys Technologies are located overseas and thus the earnings of the company are in terms of foreign currencies like US Dollars (USD), Euros etc. The excahnge rate movement of US Dollar (USD), Euro etc and the factors impacting the exchange rate of USD, Euro etc in the Indian market is a macroeconomic issue and is dependent on the macroeconomic factors like Inflation, GDP growth rate, Balance of Payments etc. It is thus beyond the capability of Infosys to control or manage such macroeconomic variables. However, any change in the value of USD or Euro vis-a vis Indian rupee impacts the earnings of Infosys. In order to manage the risk and uncertainity associted with the earnings flow, the Infosys Technologies can use hedging techniques.
In this case the issue of allocation and management of resources at the disposal of Infosys for maxisimising the gains or profit for the company is a Microeconomic issue while the issue of fluctation in the value of USD, Euro etc is an outcome of changes in the macroeconomic variables like inflation, balance of payment, GDP growth rate etc and is thus a macroeconomic issue which is beyond the control of the company.
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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 (firm, 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 market 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 or minimization of cost for a firm. It also discusses various market situations possible and determination of product pricing 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 the 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, the Welfare theory discusses and understand the criteria of 'Social Welfare' for any economy and how the same can be achieved in the economy. It also discusses the determination of welfare maximizing output-mix, commodity distribution and resource allocation.
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Ceteris Paribus |
Ceteris Paribus
It is a latin phrase which means 'Other things remain constant'. The assumption of 'Ceteris Paribus' is integral part of microeconomics theory. By using the assumption of 'Ceteris Paribus', it becomes easy to understand the relationship between two variables or in other words the impact of change in one variable on the other variable while other variables remain constant.
For example while explaining the Law of Demand, which states that There is an inverse relationship between the price and the demand of a good or service. Thus, whenever the price increases the demand for the good decreases and whenever the price decreases the demand for the good increases - provided other things remain constant or Ceteris Paribus. Here, the assumption of 'Ceteris Paribus' helps us in understanding the relationship existing between only price and the demand of good under consideration. By assuming that 'other things remain constant', it becomes easy to eliminate the impact of other factors on demand of a good or service. Here, it becomes important for us to understand that various determinants of demand are - Price of the good, price of related goods, income of an individual, advertisement, fashion, fad etc. In case,we assume that all other determinants of demand except the price of the good in question remain constant then it is possible for us to undersatnd the impact of change in only the price of a product on the demand of the product.
As already stated above, the assumption of 'Ceteris Paribus' is an integral part of economic theory and helps in exploring relation ship between following: Demand and Price, Demand and Income, Demand and price of related goods, Supply and Price, relationship between variable factors of production and the output in the short run, Impact of change in variable factors of the cost of production of a firm in the short run etc.
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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 helps in understanding that how a firm or an industry etc can maximize its production efficiency and the profit by appropriate allocation and utilization of resources at its disposal.
- Minimization of Cost - The study of Microeconomics helps in 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 give useful insight into consumer behaviour and thus help in understanding and predicting the consumer behaviour in varied market situations.
- Demand Forecasting - The theory of Demand and Demand analysis, elasticity of demand etc help in understanding and predicting 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 the good or service which the firm is offering to the market.
- Government Policy Making - The study of demand theory, supply theory, market theory etc 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 tariff on the terms of trade. Similarly, microeconomic theory of demand,supply etc helps in understanding the 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.
| Understanding Government Tax Policy |
Have you ever wondered why the tax imposed by government on Goods like Cigrattes, Liqour etc is very high? This is so because the Government understands that consumer demand for such products is inelastic and high tax rate on such goods will result in higher tax collection for the Government and thus Government comes out with the policy of high taxes on such commodities.
Similarly, if the Government of a country wishes to discourage consumption of certain Goods then it can impose very high taxes on such category of Goods. For example Government tax is very high on Imported Cars and Other Luxary Products in India.
In the same manner, if Government of a country wishes to encourage consumption of certain category of goods or may be investment in production of certain category of Goods then it reduces the related taxes for encouraging Production/Consumption of such Goods.
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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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Results |
- 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.
- Economics is thus a social science which studies following:
- How an individual uses his limited resources to maximise his well being
- How companies use their limited resources to maximise their business gains and profit
- How an Industry uses the limited resources in order to maximize gains of the firms which are part of the Industry as well as the Industry as a whole
- 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.
- Microeconomics focuses on micro or small segment of economy and it studies the decision making process and econtomic problems of individuals ( household, firm, industry etc) in an economy with respect to that how they use scarce means or resources at their disposal for satisfying their unlimted ends. On the other hand Macroeconomics looks at a larger picture and is study of economy as a whole.
- 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. In other words, we can say that Macroeconomics is the study of economy or economic systems as a whole.
- Microeconomics studies issues like demand, supply, production, production efficiency, cost, cost minimization, market structures, pricing, distribution, profit maximization etc at the individual firm, industry, household or at consumer level. On the other hand, Macroeconomics studies the economic issues and problems affecting economy at a broader level. These issues can be problem of inflation, deflation, stagflation, business cycles, problem of economic growth, national income, employment etc.
- Macroeconomic theory explains and deals with the economic environment which an individuals firms, industry, household etc face or encounter. Such issues (inflation, deflation, business cycles etc) in the economic environment impact the decision making of the individual firms, industry, households etc. However, these individual entities (focus of Microeconomic theory is on economic behaviour of individual entities) do not hold any power to control or to manage the macroeconomic issues at an individual level.
- 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
- Ceteris Peribus is a latin phrase which means 'Other things remain constant'. The assumption of 'Ceteris Paribus' is integral part of microeconomics theory. By using the assumption of 'Ceteris Paribus', it becomes easy to understand the relationship between two variables or in other words the impact of change in one variable on the other variable while other variables remain constant.
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Self-Assessment Questions (SAQs) {{{n}}} |
| Self Assessment Questions on Introduction to Microeconomics | |
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Activity |
| Try to observe how your mother or father are utilizing their monthly income in order to meet the daily reqirements of the family. Discuss with them that how changes in economic variables like inflation, slowdown of economic activity, appreciation or depreciation of domestic currency (for example Rupee) is impacting their household budgeting decision. Try to analyze and record what in your view is aspect of Microeconomic theory and what is the aspect of macroeconomic theory | |
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Key Terms |
- Macroeconomics
- Microeconomics
- Welfare theory
- Product Pricing
- Factor Pricing
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References and Bibliography |
- H.S. Agarwal, "Microeconomic Theory", Ane Books India, 2008
- G.S. Maddala and Ellen Miller, "Microeconomics - Theory and Applications", TATA McGraw Hill Publication, 2004
- A. S. Koutsoyiannis, "Modern Microeconomics", Macmillan Publication, 1980
- D.N. Dwivedi, "Managerial Economics", Vikas Publishing House, 2002
