UNIT-1

FUNDAMENTALS OF MICROECONOMICS
• Concepts of microeconomics:
Economics is a social science which studies how people interact each other, how
individuals choice to utilize scarce resources to satisfy unlimited human wants. We
can say that, economics is the science of scarcity and choice.
To analyze these issues, the economics is divided into two parts that is i.e.,
microeconomics and macroeconomics.
The term micro is derived from the Greek word “mikros” which means tiny or
small. So, microeconomics is the branch of economics which studies economic
behaviour of individual decision maker like a consumer, a producer, a worker, a
firm, etc. It examines how consumer choose between jobs and how business firms
decide what to produce, how to produce and how much to produce.

• Features of microeconomics:
a) It is individualistic economics.
b) It is based on assumption of full employment, perfect competition, etc.
c) It is also known as partial equilibrium analysis.
d) It is also known as price theory.
e) Microeconomics analysis is also known as slicing method and microscopic
method.
f) The major microeconomics variables are relative price, individual demand and
supply, output of an individual firm etc.
g) Microeconomics theories are applicable only in the free market economy.

• Scope of microeconomics:
a) Theory of demand: It is an important area of microeconomics which analysis
various determinants of demand, elasticity of demand and laws of demand. It is
studied the consumer behaviour theories like marginal utility analysis,
indifference curve analysis, etc.
b) Theory of production and cost: Goods and services are produced to fulfil
consumer’s demand. Microeconomics studies or analysis the behaviour of
producer in relation to optimum allocation of resources. Many theories of
production like law of variable, proportion laws of returns to sale, least cost
combination of inputs helps to analyze production possibilities.
c) Theory of product pricing: Goods and services produced by the firms are
offered for sell in the market to the customers with same price. Such price
depends upon the factors like cost of production, demand and supply situation,
nature of competition in market etc.
d) Theory of factor pricing: To produce goods and services the factors of
production required. For the contribution of these factors in the production,
they are paid some reward and prizes. The land gets rent, labour gets wages,
capital gets interest and organization gets profit and microeconomics studies
how these rewards or prizes are determine in different market condition.
 e) Theory of economic welfare: It is another important part of microeconomics
which concerns about the efficiency and betterment of consumers and
producers which is also known as economics welfare. The main objectives of it
is to achieve efficiency in the production and distribution. The efficiency in
production refers to the production of goods and services at the lowest
possible cost. On the other hand, efficiency in distribution occurs when goods
and services are received by those who needs the most.

• Limitations of microeconomics:
a) Static analysis: Mostly, microeconomics analysis is static where many variables
are assumed to be constant. But in reality the variables change.
b) Wrong conclusions: Microeconomics analysis is based on the individual
behaviour so it may come true in the case of individual but in aggregate, it may
totally be different. For example, saving is good on the individual basis but it is
harmful from microeconomics issues since when saving increases the
consumption will fall, similarly investment income and employment level in the
economy will also fall. So, conclusions drawn from the microeconomics analysis
may be wrong.
c) Unrealistic assumptions: Microeconomics theories have been developed on the
basis of assumptions like full employment, perfect competition, free market
economy, etc. but all these assumption are unrealistic and cannot be found in
real world.
d) Limited scope: Microeconomics studies only small units of economy which
doesn’t study all the parts of economy. It is silent about important economic
policies and problems like inflation, unemployment, poverty, inequality, etc.
Hence , microeconomics has limited scope.
e) Ignores the roles of government: Microeconomics is based on the assumptions
of free market economy where the government has limited role. But in reality,
the role of government is necessary for efficient functioning of the market
system.

• Uses/Importance of microeconomics:
a) Understanding functioning of the economy: Microeconomics is useful to
understand the economic activities and also mechanism of free market
economy. It helps to understand the determination of prices of goods and
services in the different market, behaviours of the millions of consumers and
producers in the economy.
b) Helpful to formulate economic policies: Microeconomics is useful to formulate
economic policies like pricing policies, tax policy, subsidy policy, etc. on the
basis of elasticity of demand also the policies related to international trade,
exchange rate, etc. are formulated.
c) Helpful to study human behaviour: Microeconomics is very useful to study
human behaviour. The various laws of microeconomics like law of diminishing
marginal utility, law of substitution, indifference curve, etc. helps to study
human behaviour and predict the consumer behaviour indifferent market
situations.
 d) Efficient allocation of resources: Microeconomics is also helpful for efficient
allocation of resources. Since, the resources scarce or limited in nature they
should be used wisely either in the production or in the consumption. With the
help of law of substitution the consumer is able to gain maximum satisfaction
when the ratio of marginal utilities is equal to the ratio of their policies. i.e.
𝑀𝑈𝑥 𝑀𝑈𝑦
= = 𝑀𝑈𝑚
𝑃𝑥 𝑃𝑦
Where,
𝑀𝑈𝑥 = Marginal utility of commodity X
𝑀𝑈𝑦 = Marginal utility of commodity Y
𝑃𝑥 = Price of commodity X
𝑃𝑦 = Price of commodity Y
𝑀𝑈𝑚 = Marginal utility of money
Similarly, least cost combination of input is able to explain how producers maximize
their profit i.e.
𝑀𝑃𝑙 𝑤
=
𝑀𝑃𝑘 𝑟
Where,
𝑀𝑃𝑙 = Marginal productivity of labour
𝑀𝑃𝑘 = Marginal productivity of capital
𝑤 = Wage rate
𝑟 = Rate of interest
e) Basis of welfare economics: Microeconomics is the basis of social welfare.
Welfare economics is concern with the betterment of consumers, producers
and overall economy and it is possible only in the perfect competition. Also, it
helps in the selection of good tax system in the country without affecting social
and economic welfare.

• Uses of microeconomics in business decision making:

For the business decision, microeconomics provides analytical tools.
Microeconomics is useful to make business decisions which involve optimum
allocation of resources, pricing cost analysis, production decision, prediction of
future demand or sales, etc. The major roles of microeconomics in business
decision making are explained as:
a) Demand and sales forecasting: Microeconomics is useful to analyze and
forecast the future demand of a product. Demand of a product generally
depends upon its price, income of the consumer, price of the related goods,
size of population, advertisement, etc. On the basis of these determinants,
business firms forecast future demand and present scales of the product.
b) Cost analysis: Microeconomics analysis different types of cost of production,
factors determining cost of production and different method of minimizing
cost. On the basis of these analysis, a firm can estimate cost of production
before making business decision.
c) Price determination: On the basis of important functions of a firm, i.e. price
determination, which depends upon many factors like demand, supply, nature
 of competition, price of related goods, price elasticity of demand, etc. are
useful in determining the price of the product.
d) Optimum production decision: Production decision is related with the choice of
technique of production and microeconomics helps to find out the optimal
production decision.
e) Optimal resources utilization: Since, the resources are limited in nature,
microeconomics dials with how these scares resources are allocated efficiently
in the production of goods and services. It also helps to decide what to
produce, how to produce, how much to produce and for whom to produce.
f) Advertising decision: Advertisement is the most important tool to improve the
sales of the product. Through, advertisement elasticity of demand which is
studied under microeconomics, helps to decide whether advertisement should
be increased, decreased or maintained at the existing level.

• Basic principles of economics:

(A) How people make decisions
a) People face trade-off: To get one thing, we have to give something else.
This is known as the trade-off. For example, if we work, we don’t get
leisure time.
b) The cost of something is what you give up to get it: Making a decision
requires comparing the cost and benefits of alternative courses of
action. The cost of option is whatever best next alternative we give up.
This is known as the opportunity cost. i.e. opportunity cost of college
students is earning from job given up to attend college.
c) Rational people think at the margin: In economics, people are assumed
to be rational. Rational people are those who systematically and
purposefully do the best they can do to achieve their objectives. It
means the rational people or firms make decisions on the basis of
marginal changes in cost and benefit.
d) People respond to incentives: An incentive is something that includes a
person to act, such as the prospect of a punishment or a reward. The
marginal changes in costs and benefits motivate people to respond. i.e.
when price of apple rises, its production and supply will increases. Here,
profit is incentive to increase the production of apple.
e) Trade between the countries can make each country better off: The high
living standard of people in the present world is due to trade. i.e. we are
enjoying from variety of goods like car produced in Japan, computer
produced in U.S.A., etc. If there was no foreign trade in Nepal, we would
not get those goods.
(B) How people interact
f) Markets are usually good way to organize economic activity: Market is
the means of exchanging goods and services as a result of buyers and
sellers being in contact with one another either directly or indirectly
through mediating agents or institutions. The market economics has
proven remarkably successful in organizing economic activities to
 produce or promote overall economic well-being than the centrally
planned or socialist economics of the world.
g) Governments can sometimes improve market outcomes: When market
fails to allocate resources efficiency this is known as market failure. The
main cause of market failure are existence of externalities and market
power. In this situation, government improves market outcomes
through its policy, interventions like taxes, subsidies, patent laws, etc.
(C) How the economy as a whole works
h) A country’s standard of living depends on its ability to produce goods
and services: Ability to produce goods and services is the most important
factor determining country’s standard of living. It is related with this
productivity, i.e. quantity of goods and services produced from each unit
of labour input. Growth rate of nations productivity determines growth
rate of its average income. For e.g. Chinese have higher living standard
than Nepalese, Indian and Pakistanis because of their higher productivity
or higher ability to produce goods and service than these countries.
i) Prices rise when the government prints too much money: The rise in
overall level of price in an economy is known as the inflation. The main
cause of inflation is increase in the quantity of money or money supply
i.e. very high rate of inflation, i.e. more than 1000 percentage in the
most of the European countries like Germany, Hurgary, etc. During
1920’s was due to rapid growth in the quantity of money.
j) Society faces a short-run trade-off between inflation and
unemployment: There is short run trade between inflation and
unemployment. The curve that shows the short-run trade-off between
inflation and unemployment is called Philip’s curve. This curve explain
that higher the inflation, lower will be the unemployment and lower the
inflation, higher will be the unemployment. Firms hire more workers and
produce a large quantity of goods and services. Thus, more hiring of
labour means lower unemployment and vice-versa.