Microeconomics

LECTURE 1 – AN INTRODUCTION TO ECONOMICS

PRELIMINARIES

Economics is divided into two main branches: microeconomics and macroeconomics.

Microeconomics deals with the behaviour of individual economic units. These units include
consumers, workers, investors, owners of land, business firms – any individual or entity that
plays a role in the functioning of the economy. Microeconomic explains how and why these
units make economic decisions. For example, it explains how consumers make purchasing
decisions and how their choices are affected by changing price and incomes. It also explains
how firms decide how many workers to hire and how workers decide where to work and how
much work to do.
By contrast, macroeconomics deals with aggregate economic quantities, such as the level and
growth rate of national output, interest rates, unemployment and inflation.

THE THEMES OF MICROECONOMICS

Much of microeconomics is about limits-the limited incomes that consumers can spend on
goods and services, the limited budgets and technical know-how that firms can use to product
things, and the limited number of hours in a week that workers can allocate to labour or
leisure. Microeconomics is also about ways to reduce the impact of these limits. More
precisely, it is about the allocation of scarce resources. Microeconomics describes the
trade-offs that consumers, workers and firms face, and show how these trade-offs are best
made.
Scarce resources
What do we mean by economic resources? In general, we refer to all the natural, human, and
manufactured resources that go into the production of goods and services. Let us examine the
various categories of resources (or factors of production).
Land – refers to all natural resources, all “free gifts of nature” that are usable in the
production process. Such resources are arable land, mineral and oil deposits, forests and water
resources.
Capital – refers to all manufactured aids to production, that is all tools, machinery,
equipment, factory, storage, transportation and distribution facilities used in producing goods

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and services and getting them to the ultimate consumer. Notice that the term capital as here
defined does not refer to money. In fact, money is available for purchasing of machinery,
equipment and other production facilities. But money, as such, produces nothing: hence it
may not be considered as an economic resource.
Labour – is a broad term, which an economist uses in referring to all the physical and mental
talents of men and women, which are usable in producing goods and services.
Entrepreneurship – we can distinguish some features of an entrepreneur:
− The entrepreneur takes initiative in combining the resources of land, capital, and labour in
the production of goods and services.
- He or she takes business - decisions that are often strategic in nature.
- The entrepreneur is an innovator, the person who attempts to introduce new products,
new technologies or new forms of business organisation.
- The entrepreneur is obviously a risk bearer and has no guarantee of profit. The reward
for his or her time, efforts and abilities may be attractive profits or losses and eventual
bankruptcy.

Production possibilities curve (transformation curve)

As economic resources are limited or scarce, there is a problem how to optimally allocate
these resources. The problem can be analysed with the use of production possibilities curve.
We make several assumptions to illustrate the problem.
1. Efficiency – the economy is operating at full employment of production factors, which
means that all available production factors should be used in the production process.
2. Fixed resources – the available quantity of production factors is fixed. Of course, they
can be shifted among different uses. For example, relatively unskilled worker can work on
a farm, in a petrol station or in McDonalds.
3. Fixed technology – The level of technology is fixed; it does not change during the time of
our analysis. The second and third assumptions say that we are looking at our economy at
some specific point of time, or over a very short period of time.
4. Two products – to simplify our illustration further, suppose our economy is producing
just two products: bread and machines. Bread is a symbol of consumer goods, which
directly satisfy our wants. Machines are a symbol of capital (investment) goods, which
satisfy our wants indirectly by permitting more efficient production of consumer goods.

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Necessity of choice

Now it is evident from our assumptions that an economy faces a problem of choice. Our
resources are limited. Thus the amount of bread and machines that our economy is able to
produce is also limited. Limited resources mean a limited output. A choice must be made
what quantity of each product society wants to produce. Since resources are limited any
increase in the production of machines mean shifting of resources from the production of
bread. And the reverse holds true.
Let us take an example of some alternative combinations of machines and bread, which our
economy may choose (Table 1).

Table 1

Alternatives A B C D E F G H I J
Production of
Bread (thousand 1400 1350 1300 1200 1100 960 800 600 400 0
tons)
Production of
machines 0 100 140 200 250 300 350 400 440 500
(thousand items)

At alternative A, our economy will devote all its resources to the production of bread
(consumer goods). At alternative J all resources will be devoted to the production of machines
(investment goods). Both these alternatives are unrealistic extremes. Typically any economy
divides its total output between consumer and capital goods. As we move from alternative A
to J, we resign the production of bread by shifting resources away from consumer goods
production. So the society chooses to forgo current consumption. Coming back from J to A,
the society increases current satisfaction of its wants. The critical idea is this: At any point of
time, a full-employment economy must sacrifice some of product X to obtain more of
product Y. The fact that economic resources are scarce prohibits such an economy from
having more of both goods.
Let us view this data graphically. We take a graph and put the output of machines (capital
goods) on the vertical axis and the output of bread (consumer goods) on the horizontal axis
(Figure 1). Following the plotting procedure we can locate the production possibilities curve
(transformation curve).

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 Figure 1. Production possibilities curve

Each point on the production possibilities curve represents some maximum output of the two
products. To obtain the various combinations of bread and machines, which lie on the curve,
society must achieve full employment of resources. All combinations of bread and machines
on the curve represent maximum quantities attainable only as a result of the most efficient use
of all available resources. Points lying outside the production possibilities curve, like point L,
would be superior to any point on the curve. But such points are not available given the
current amounts of resources and technology.

Law of increasing costs

We said that all resources are scarce and choice among alternatives has to be made. More of
consumer goods mean less of investment goods. The amount of other product that must be
sacrificed to obtain a unit of a given product is called the opportunity cost of that good.
In our case the amount of bread that must be given up to get additional number of machines is

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the opportunity cost of machines. Hence, in moving from possibility A to B in table 1, we find
that the cost of 50 units of bread is 100 machines. In moving from alternative A to J, the cost
of bread involved in getting each additional unit of machines increases. Graphically, the law
of increasing costs is reflected in the shape of the production possibilities curve. The curve is
concave from the origin. What is the economic explanation for the law of increasing
costs? The answer is as follows: economic resources are not completely adaptable to
alternative uses. As we attempt to increase the production of machines, resources, which are
less and less adaptable in machines production, must be shifted there. If we start from A to B,
we can first take resources which productivity of machines is high in relation to their
productivity of bread. But as we move from B to C, C to D and so on, the resources, which
are highly productive in machines production, become increasingly scarce. Therefore we
should take more and more of such resources to achieve a given increase in machines
production. So, the law of increasing costs results from lack of perfect flexibility of
economic resources. If resources were perfectly adaptable, the production possibilities
curve would be a straight line, implying constant opportunity cost.

It is important to understand what happens when the first free assumptions concerning the
production possibilities curve are released.
The first assumption was that our economy is characterized by full employment of
production factors. How would our analysis change if there were resources that are wasted?
What would happen if there was unemployment in the economy? In such a case, the economy
would produce less than each alternative shown in the table. Graphically, a situation of
unemployment can be illustrated by a point inside the production possibilities curve, for
example by point K.
What would happen to the production possibilities curve when we drop the remaining
assumptions that the quantity of resources and technology are fixed? The answer is: the
production possibilities curve will shift position. This means that potential output of the
economy will change.
Let’s now drop our assumption that the quantities of land, capital, labour and
entrepreneurship are fixed. It is true over a period of time – a growing population will
increase both labour and entrepreneurship resources. A stock of capital increases due to
investment process. And new mineral resources are constantly being discovered. Therefore,
the economy is able to produce more of both consumer and capital goods.

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What about changes in technology? Observation tells us that it means new and better
products and improved ways of producing these products. Technological advance by
improving efficiency of production, allows society to produce more goods with a fixed
amount of resources.
In both cases, more economic resources and improved technology, the production possibilities
curve will shift to the right. We could say that economic growth – the ability to produce a
larger total output – is reflected in a rightward shift of the production possibilities curve. It is
a result of increases in quantity of economic resources and/or of technological progress.

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 SUMMARY

Microeconomics is concerned with the decisions made by small economic units – consumers,
workers, investors, owners of resources, and business firms.

Macroeconomics deals with aggregate economic quantities, such as the level and growth rate
of national output, interest rates, unemployment and inflation.