MICROECONOMICS THEORIES

Assumptions in Microeconomic Theory

● Microeconomic theory begins with a single objective analysis and individual

utility maximization. To economists, rationality means an individual’s
preferences are stable, total, and transitive.
● It assumes continuous preference relations to ensure that the utility function is
differentiable when you compare two different economic outcomes.
● The microeconomic model of supply and demand assumes that the markets are
perfect. It means that there are a large number of buyers and sellers in the
market, and none of them can influence the price of products and services
significantly. Nonetheless, in real-life cases, the principle fails when any buyer
or seller controls prices.

Theories in Microeconomics

1. Theory of Consumer Demand

The theory of consumer demand relates goods and services consumption preference to
consumption expenditure. Such a correlation provides a way for consumers, subject to budget
constraints, to achieve a balance between expenses and preferences by optimizing utility.

The fundamental premise of consumer demand theory is an observation of the way individual act
to divide their limited resources among the commodities that divide them with satisfaction.

Law of Demand : Prices increase, quantity demanded decreases

2. Theory of Production Input Value

According to the production input value theory, the price of any item or product is determined by
the number of resources spent to create it. Cost may include several of the production factors
(including land, capital, or labor) and taxation. Technology may be regarded as either circulating
capital (e.g., intermediate goods) or fixed capital (e.g., an industrial plant).

3. Production Theory

The production theory in microeconomics explains how businesses decide on the quantity of raw
material to be used and the quantity of items to be produced and sold. It defines a relationship
between the quantity of the commodities and production factors on the one hand, and the price of
the commodities and production factors on the other.

4. Theory of Opportunity Cost

According to the opportunity cost theory, the value of the next best alternative available is
the opportunity cost. It depends entirely on the valuation of the next best option and not on the
number of options.

The Theory of Consumer Behavior- The principle assumption which the theory of consumer
behavior and demand is built is: a consumer attempts to allocate his/her limited money income
among available goods and services so as to maximize his/her utility (satisfaction)

Theories of Consumer Choice:

Utility Concepts:

-The Cardinal Utility Theory (TUC)

Utility is measurable in cardinal sense

Cardinal utility- assumes that we can assign values for utility (Jevons, Walras and Marshall) E.g
derive 100 utils from eating a slice of pizza

The Ordinal Utility Theory (TUO)

Utility is measurable in an ordinal sense

Ordinal utility approach- does not assign value, instead works with a ranking of preferences
(Pareto, Hicks, Slutsky)

Theory of Consumer Behavior – useful for understanding the demand side of the market side

Utility- amount of satisfaction derived from the consumption of a commodity

..measurement units – utils

Utility means satisfaction. More precisely, it refers to how consumers rank different goods and
services. In economics, utility is measures in units.

Total Utility- The overall level of satisfaction derived from consuming a good or service

-the total benefit that a person gets from the consumption of goods and services

Marginal Utility- additional satisfaction

Law of Diminishing Marginal Utility (Return)- As more and more of a good are consumed, the
process of consumption will at some point yield smaller additions to utility

When the total utility maximum, marginal utility=0

When the total utility begins to decrease, the marginal utility – negative (-ve)

The basic economic problem is the issue of scarcity. Because resources are scarce but wants are
unlimited, people must make choices. This lesson showcases the most important concept in
macroeconomics, which is the concept of opportunity cost. Very simply, everyone has the same
amount of hours in a day, but we all make different decisions about what we do, what we choose
to buy, and how we spend our time. What determines these choices? Opportunity cost does.

Opportunity cost helps us determine how we spend our time.

opportunity cost determines our time management

Every time you make a choice, there is a certain value you place on that choice. You might not
know it or think about it, but every choice has a value to you. When you choose one thing over
another, you're saying to yourself, ''I value this more than another choice I had.''

The opportunity cost of a choice is what you gave up to get it. If you have two choices - either an
apple or an orange - and you choose the apple, then your opportunity cost is the orange you could
have chosen but didn't. You gave up the opportunity to take the orange in order to choose the apple.
In this way, opportunity cost is the value of the opportunity lost.

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Value: Benefits and Cost

Opportunity cost is all about weighing the costs and benefits for each option.

opportunity cost

Value has two parts to it. It has benefits as well as costs. If you choose an apple over an orange,
maybe the apple costs less, but maybe you enjoy it more. So, looking at choice in terms of benefits
and costs helps you make better economic decisions. To make a good economic decision, we want
to choose the option with the greatest benefit to us but the lowest cost.

Monetary Value

For example, if we graduate from college and suddenly find ourselves in the job market, there are
choices to be made. Let's say that two jobs become available to us. We can either work for
Company A or Company B. The job with Company A promises to pay us $20 an hour, while
Company B offers to pay us only $10. Based on this information alone, of course most people
would choose Company A.

Economist define profits as one of the factors

Is the total revenue that a firm earns by selling one or more unit of output
Marginal cost is the extra cost that a firm incurs by producing one more unit of output
Production theory is the study of production, or the economic process of converting inputs into
outputs. Production uses resources to create a good or service that is suitable for use, gift-giving
in a gift economy, or exchange in a market economy. This can include manufacturing, storing,
shipping, and packaging. Some economists define production broadly as all economic activity
other than consumption. They see every commercial activity other than the final purchase as
some form of production.
Firm is an insturtion that aims the