Introduction to Microeconomics

Introduction to Economic Theory

Economic theories try to explain economic phenomena, to interpret why and
how the economy behaves and what is the best to solution - how to influence or
to solve the economic phenomena. They are comprehensive system of
assumptions, hypotheses, definitions and instructions what should be done in a
certain economic situation.
All economic theories used to explain specific situations or problems in the
economy of some of its models. These models of economic systems try to
explain the situation and solve it using approaches that are typical of the
economic theory (eg. Keynesian theory subdued stimulate the economy
through government money).
Problem of Scarcity
Economics is mainly concerned with the achievements and uses of material requirements to satisfy human
wants. However, human wants are unlimited and productive resources like land, labor, raw materials, skilled
manpower, capital equipment’s etc. are limited. Hence, it is impossible to produce goods and services so as to
satisfy all wants of people. Therefore, goods and services which satisfy human wants are scare. This mismatch,
between what people want and the maximum that can be produced, gives rise to the economic problem. Every
economic system has to deal with this central problem of scarcity of resources relative to wants for them. The
Central Economic Problem is further divided into three basic economic problems. These are:
1. What to Produce: An economy has unlimited wants and limited resources having alternative uses.
Economy cannot produce all the goods and services as it desires. Therefore, economy has to make a choice
what type of goods and services are to be produced and in what quantities by using the existing resources.
2. How to Produce: This means which methods of production are to be used for the production of goods and
services. There are two types of production techniques:
Labor Intensive Technique: - It is the technique of production when labor is used more than capital.
Capital Intensive Technique: - In this technique capital is used more than Labor.
An economy must decide as to which technique is to be used in a given industry so that efficient production is
obtained.
3. For whom to Produce: This means how the goods and services produced are to be distributed among the
people. It refers the way that output is distributed among the member of the society.
Microeconomics

The English word micro is derived from a Greek word ‘mikros’ which means small.
Microeconomics studies the economic behavior of an individual unit. The individual unit
may be a person, a particular household, or a particular firm. It is a study of one particular
unit rather than all the units combined together. Microeconomics is concerned with
microscopic study of various elements of economic system. It does not study the economy in
its totality.
According to K. E. Boulding, “Microeconomics is the study of particular firms, particular
households, individual prices, wages, incomes, individual industries, particular
commodities”.
Thus microeconomics studies the behavior of individual decision making units such as
consumers, resource owners, and business firms. Microeconomics primarily concerned with
the determination of price of commodities and factors of production. So it is often called
price theory or value theory.
Macroeconomics

The English word ‘macro’is derive from a Greek word ‘makros’ which means large.
Macroeconomics is related with aggregate or total economic activities. Macroeconomics is
not the study of individual units but all units combined together. It is the study of economic
system as a whole. Macroeconomic study deals with economic aggregate like national
income, employment, aggregate consumption, savings and investment, and general price
level.
According to K. E. Boulding, “Macroeconomics is that part of economics which studies the
overall averages and aggregates of the system.”
Thus, macroeconomics is the study of aggregate or the economy as a whole. For example,
macroeconomics explains how the level of income and employment is determined. It also
explains how national income grows overtime. Thus macroeconomics deals with the
phenomena related with the level and growth of national income and employment. Therefore,
macroeconomics is also known as Theory of Income and Employment.
 Types of Microeconomics
1. Micro statics
Micro statics refers to the stationary situation of the equilibrium between different variables at
certain point of time. In other words, when the values of economic variables are related to the
same point of time, the functional relationship between variables is said to be statics.

It is expressed as
The concept of micro statics has been illustrated in the following figure as;

Y D S

Price
P

S
D
0 Q X
Quantity
The figure shows the equilibrium of the market in a certain point of time. Both the demand
curve DD and supply curve SS have intersected each other at point E in a particular point in
time. So E is the point of equilibrium which relates two of the variables price (OP) and
quantity (OQ) at a particular point in time. This is a static analysis
 2-Comparative Micro Statics

As time passes, there is change in the condition of demand and supply. This change in demand
and supply brings a change even in the equilibrium condition. This type of change in
equilibrium at different points of time is the study of comparative micro statics. Therefore
comparative micro statics is the study of different equilibriums at different points of time.

Comparative micro statics compares one equilibrium with other equilibrium but it does not
study about the process how one equilibrium breaks and another equilibrium establishes. The
comparative micro static can also be shown in the figure below as,
 Y
D1
S
D
E1
P1
E

Price
P

S D1
D
0 X
Q Q1
Quantity

In the figure E is the initial equilibrium, where equilibrium price is OP and equilibrium
quantity is OQ. When the demand rises from DD to D1D1, the new equilibrium shifted from
E to E1 where the equilibrium price is OP1 and equilibrium quantity is OQ1. The
comparative study of the two equilibrium points E, E1 is the comparative micro statics but
this study does not explain about the process how a new equilibrium attains.
 3-Micro Dynamics

There is always change in time. This change brings change in price and the demand & supply
of quantity of commodities. Consequently, there is a change in equilibrium. Therefore, micro
dynamics refers to that situation of equilibrium in which an equilibrium of different variables
goes through disequilibrium and new equilibrium establishes. Hence micro dynamics is the
study of the process which shows how the initial equilibrium breaks and new equilibrium
attains. Micro dynamics can also be explained by the following figure.
 Y D1
S

P5 A B
P4 F
D
P3
Price
E1
P2 C
P1 E
D1

S
D
0 Q1 Q2 Q3 Q4 X
Quantity
In the figure, E is the initial point of equilibrium at which 0P1 price & 0Q1 quantity are the
equilibrium price & equilibrium quantity. Now let us suppose that there is an increase in
income at given price 0P1. The increase in income causes a shift in demand curve from DD to
D1D1. This brings about a disequilibrium in the market and the series of disequilibrium
persists until the new equilibrium reached at point E1.
Let’s start the process from disequilibrium to new equilibrium. The increase in demand
cannot be fulfilled by increasing in supply immediately. So the price level rises from 0P1 to
0P5 by EA. This rise in price encourages the suppliers to increase in supply from 0Q1 to 0Q4.
Now supply is more than demand by AB and 0Q4 quantity is demanded only at price 0P2. So
the price falls from 0P5 to 0P2. This fall in price causes a fall in supply from 0Q4 to 0Q2 or the
supply is equal to 0Q2.
But demand is still higher than supply which pushes the price up from 0P2 to 0P4. Again the
suppliers are encouraged to increase in supply. This process continues again & again until the
final point of equilibrium is reached at price 0P3 & quantity at 0Q3.
This is how micro dynamics explain about the process how an equilibrium breaks and
another new point of equilibrium establishes.
 Uses and Importance of Microeconomics

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 Behavior - The study of Marginal Utility theory, Consumer
Indifference curves etc. give useful insight into consumer behavior and thus help in
understanding and predicting the consumer behavior in varied market situations.
 Uses and Importance of Microeconomics…

Demand Forecasting - The theory of Demand and elasticity of demand help in

understanding and predicting demand of a product.

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.
 Limitations of Microeconomics
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
experienced the full employment scenario till date.
- Microeconomic theory assumes of a 'Lassiez Faire' economic system. This means an
economic system having 'No government intervention'. 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 behavior 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.