Chapter 1

Introduction to Microeconomics
What is Economics?

The first notable work on Economics is Kautilya’s ‘Arthshastra’ (4th century BC)

Economics comes from the ancient Greek word “oikonomikos” or “oikonomia.”

Oikonomikos literally translates to “the task of managing a household.” French mercantilists
used “economie politique” or political economy as a term for matters related to public
administration.

Economics

Adam Smith’s Definition of Economics

Adam Smith was a Scottish philosopher, widely considered as the first modern economist.
Smith defined economics as “an inquiry into the nature and causes of the wealth of nations.”

Criticism of Smith’s Definition

The wealth-centric definition of economics limited its scope as a subject and was seen as
narrow and inaccurate. Smith’s definition forced the subject to ignore all non-wealth aspects
of human existence.

The Smithian definition over-emphasized the material aspects of well-being and ignored the
non-material aspects. It was assumed that human beings acted as rational economic agents
who mindlessly strived to maximize their own well-being.

The Smithian definition prevents the subject from exploring the concept of resource scarcity.
The allocation and use of scarce resources are seen as a central topic of analysis in modern
economics.

Alfred Marshall’s Definition of Economics

British economist Alfred Marshall defined economics as “the study of man in the ordinary
business of life”. Marshall argued that the subject was both the study of wealth and the study
of mankind. He believed it was not a natural science such as physics or chemistry, but rather
a social science.

Economics is the study of mankind in the ordinary business of life. It studies that part of
economic activities which are performed to satisfy the materialistic needs of men with the
monetary resources.

Criticism of Marshall’s Definition

The Marshallian definition, like the Smithian definition, ignored the problem of scarce
resources, which possess unlimited potential uses.

Marshall’s definition restricted economics as a subject to only analyze the material aspects of
human welfare. Non-material aspects of welfare were ignored. Critics of the Marshallian
definition asserted that it was difficult to separate material and non-material aspects of
welfare.

The Marshallian definition does not provide a clear link between the acquisition of wealth
and welfare. Marshall’s critics claimed that it left the subject in a state of perpetual confusion.
For instance, there are plenty of activities that might generate wealth but that can reduce
human welfare.

Lionel Robbin’s Definition of Economics

Lionel Robbin, another British economist, defined economics as the subject that studies the
allocation of scarce resources with countless possible uses. In his 1932 text, “An Essay on the
Nature and Significance of Economic Science,” Robbins said the following about the subject:
“Economics is the science which studies human behaviour as a relationship between ends and
scarce means which have alternative uses.”

People choose/select the things for which they think the net gain is the greatest.

Dry-fruits or Liquor

Criticism of Robbin’s Definition

Robbin’s definition of economics transformed the subject from a normative social science
into a positive science with an undue emphasis on individual choice. His definition prevented
the subject from analyzing topics such as social choice and social interaction theory, which
are important topics within the modern microeconomic theory.

Robbin’s definition prevented it from analyzing macroeconomic concepts such as national

income and aggregate supply and demand. Instead, economics was merely used to analyze
the action of individuals, using stylized mathematical models.

Modern Definition of Economics

The modern definition, attributed to the 20th-century economist, Paul Samuelson, builds
upon the definitions of the past and defines the subject as a social science. According to
Samuelson, “Economics is the study of how people and society choose, with or without the
use of money, to employ scarce productive resources which could have alternative uses, to
produce various commodities over time and distribute them for consumption now and in the
future among various persons and groups of society.”

Meaning of Economics

Economics is optimizing needs with scarce resources and the given constraints.
Scope of Microeconomics
The scope or the subject matter of microeconomics is concerned with:

Commodity pricing
The price of an individual commodity is determined by the market forces of demand and
supply. Microeconomics is concerned with demand analysis i.e., individual consumer
behaviour, and supply analysis i.e., individual producer behavior.
Factor pricing theory
Microeconomics helps in determining the factor prices for land, labor, capital, and
entrepreneurship in the form of rent, wage, interest, and profit respectively. Land, labor,
capital, and entrepreneurship are the factors that contribute to the production process.
Theory of economic welfare
Welfare economics in microeconomics is concerned with solving the problems in
improvement and attaining economic efficiency to maximize public welfare. It attempts to
gain efficiency in production, consumption/distribution to attain overall efficiency and
provides answers for ‘What to produce?’, ‘How to produce?’, and ‘For whom it is to be
produced?’ what provision should be made to ensure future growth and development.
Significance of Microeconomics in Business Decision Making
Microeconomics plays a vital role in assisting the business firms and business decision
makers. Some of the major functions of microeconomics in business decision making are
listed below:
Optimum utilization of resources
The study of microeconomics helps the decision makers to analyze and determine how the
productive resources are allocated for various goods and services. It also helps in solving the
producers’ dilemma of what to produce, how much to produce and for whom to produce.
Demand analysis
With the help of microeconomic analysis, business firms can forecast their level of demand
within the certain time interval. The demand for a commodity fluctuates depending upon
various factors affecting it. Thus, business firms and decision makers can determine the level
of demand for the commodity.
Cost analysis
Microeconomic theories explain various conditions of cost like fixed cost, variable cost,
average cost, and marginal cost. Along with this, it also provides an analysis of the short run
and long run costs that help the business decision makers determine the cost of production
and other related costs, so they can implement policies to cut down cost and increase their
level of profit.
Free Market Economy
Microeconomics explains the operating of a free market economy where, an individual
producer has the freedom to take economic decisions like what to produce, how to produce,
or for whom to produce. Allocation of resources is determined by price or market mechanism
i.e., interaction between demand and supply
Production decision optimization
Microeconomics deals with different production techniques that help to find out the optimal
production decision which helps the decision makers to determine the factors needed in order
to produce a certain product or a range of products.
Pricing policy
Microeconomic analysis provides business managers with a thorough knowledge of theories
of production and pricing in order to ensure optimum profit for the firm in the long run.
Determination of Relative Prices of Products & Factors of production
Microeconomics helps in analysing market mechanisms i.e., determinants of demand and
supply which are responsible for the determining prices of commodities in the market. Along
with this, it provides an insight on theories relating to prices of a factor of rent, wage, interest,
and profit.
Basis of Managerial Economics
Microeconomics used for the study of a business unit, but not the economy as a whole is
known as managerial economics. The various tools used in microeconomics like cost and
price determination, at an individual level becomes the foundation of managerial economics.
Basis of Welfare Economics

Microeconomics is not only concerned with analysing economic condition but also with the
maximization of social welfare. It studies how given resources are utilized to gain maximum
benefit under various market conditions like monopoly, oligopoly, etc. Analysis of
production efficiency, consumption efficiency, and overall economic efficiency are
conducted on the basis of microeconomics.
Formulation of Public Economic Policies
Microeconomics tools are useful for introducing policies relating to tax, tariff, debt, subsidy,
etc. it helps the governmental bodies to fixate on the tax rate, types of tax, and the amount of
tax to be charged to buyers and sellers.
Helpful in Foreign Trade
Microeconomics is useful in explaining and determining the rate of foreign exchange
between currencies, fixing international trade and tariff rules, defining the cause of
disequilibrium in the balance of payment (BOP), and formulating policies to minimize it.
Limitation of microeconomics
Microeconomics is most important branch of economics. It is also known by foundation for
whole economic analysis. It describes about the individual behavior of society and firm.
According to William Flenar,” Micro economics is related to the individual decision-making
units.” It tells us how price and output level of any commodity is determined? How cost of
production is determined? What we mean by market and its types? How wage rate and
payment for capital is defined? How the government policy affects all such activities? etc.
Beside such important aspects of microeconomics, it has some imitations as given below

Individual analysis

Microeconomics explains only small individual units of economic activity. This is a partial
and incomplete analysis. For the national economic analysis, aggregate income and output,
aggregate production and expenditure show the economic level of country. All those subjects
are not considered by microeconomics. So it is regarded as the incomplete matter.

Impractical assumption

Most of theories and models of microeconomics are derived based upon some assumption for
examples: other things remaining same, full employment, concept of rationality etc. In real
life it’s near impossible to be fulfilled those assumptions. In our daily activities, there are
many variable factors along with time. Those changes in variables bring the change in
individual behavior that affects microeconomic activity. Same way, it is impossible to be full
employment in economy.

Wrong concept of laissez faire economy

Microeconomics belief upon the concept of laissez faire economy that means there should be
no interfere in market economy by government. It has been explained in market life that
government should interfere for its smooth activities. An event of great depression- 1930 had
made failure to the concept of laissez faire.

Micro economics ignores the macro level activity

Real economic mirror of a country is employment, income, output, foreign trade, price level,
impact of policy (monetary and fiscal) implementation etc. But microeconomics does not
analysis all those subjects.

Difference between Micro and Macro

 Microeconomics is the study of decisions made by individuals and businesses

regarding the allocation and utilization of resources. It also looks after the prices at
which individuals trade their goods and services, keeping the taxes, regulations, and
government legislation in consideration.
 While
Macroeconomics, on the other hand, studies the decisions made by governments in a
country and the impact of the policies framed on the economy as a whole.
Macroeconomics analyzes entire industries and economies rather than focusing on the
decisions of private individuals or companies. It tries to answer questions such as,
"What should the rate of inflation be?" or "What stimulates economic growth?"

 Microeconomics focuses on supply and demand and other factors that affect the price
levels. In other words, microeconomics tries to understand human choices made,
decisions taken, and allocation of resources. Microeconomics does not try to suggest,
answer, and explain what forces should take place in a market but it rather tries to
explain the effect of certain changes made in the market conditions.
While
Macroeconomics focuses on aggregates and economic correlations. This is the reason
behind government agencies’ reliance on macroeconomics to frame economic and
fiscal policy. Investors who buy interest-rate sensitive securities should keep a close
eye on monetary and fiscal policy. Outside a few meaningful and measurable impacts,
macroeconomics doesn't offer much for specific investments.

 Microeconomics examines the market situation for a company. It looks at the ways
the company could maximize its production and capacity so that it can lower the
prices of goods or services. This helps the company to better place itself and survive
the fierce competition. So, in simple words, we can say that microeconomics helps
individuals to grow.
While
Macroeconomics, on the other hand, analyzes how an increase or decrease in net
exports impacts a nation's capital account, or how gross domestic product (GDP) is
impacted by the unemployment rate. So, we can say, macroeconomics makes things
clear at the broad level that helps the government to formulate economic policies.

 Microeconomics takes a bottom-up approach to analyze the economy whereas

macroeconomics takes a top-down approach.
While
Macroeconomics deals with the performance, structure, and behavior of the entire
economy, in contrast to microeconomics, which is more focused on the choices made
by individual actors in the economy (like people, households, industries, etc.).

Principles of Economics (How do people take decisions?)

Principles of Micro Economics

1. People face trade-offs (Principle of Trade-off)

“There is no such thing as a free lunch (TINSTAAFL).” To get one thing that we like, we
usually have to give up another thing that we like. Making decisions requires trading one goal
for another. Examples include how students spend their time, how a family decides to spend
its income, how the government spends revenue, and how regulations may protect the
environment at a cost to firm owners. A special example of a trade-off is the trade-off
between efficiency and equality.
Definition of efficiency: the property of society getting the maximum benefits from its scarce
resources.
Definition of equality: the property of distributing economic prosperity fairly among the
members of society.
For example, tax paid by wealthy people and then distributed to poor may improve equality
but lower the incentive for hard work and therefore reduce the level of output produced by
our resources. This implies that the cost of this increased equality is a reduction in the
efficient use of our resources.
Another Example is “guns and butter”: The more we spend on national defence (guns) to
protect our borders, the less we can spend on consumer goods (butter) to raise our standard of
living at home.
Recognizing that trade-offs exist does not indicate what decisions should or will be made.
2. Opportunity cost principle and its significance in decision making
Because people face trade-offs, making decisions requires comparing the costs and benefits
of alternative courses of action. The cost of going to college for a year is not just the tuition,
books, and fees, but also the foregone wages. Seeing a movie is not just the price of the
ticket, but the value of the time you spend in the theatre. This is called opportunity cost of
resource
Definition of opportunity cost: whatever must be given up in order to obtain some item next
best alternative forgone
When making any decision, decision makers should consider the opportunity costs of each
possible options
3. Principle of Rationality
Economists generally assume that people are rational.
Definition of rational: systematically and purposefully doing the best you can to achieve your
objectives.
Consumers want to purchase the bundle of goods and services that allow them the greatest
level of satisfaction given their incomes and the prices they face. Firms want to produce the
level of output that maximizes the profits. Many decisions in life involve incremental
decisions: Should I remain in school this semester? Should I take another course this
semester? Should I study an additional hour for tomorrow’s exam? Rational people often
make decisions by comparing marginal benefits and marginal costs.
If the additional satisfaction obtained by an addition in the units of a commodity is equal to
the price a consumer is willing to pay for that commodity, he achieves maximum satisfaction,
which is the main goal of every rational consumer.
Example: Suppose that flying a 200-seat plane across the country costs the airline
$1,000,000, which means that the average cost of each seat must cost $5000 to break even.
Suppose that the plane is minutes away from departure and a passenger is willing to pay
$3000 for a seat. Should the airline sell the seat for $3000? In this case, the marginal cost of
an additional passenger is very small.
Another example: Why is water so cheap while diamonds are expensive? Because water is
plentiful, the marginal benefit of an additional cup is small. Because diamonds are rare, the
marginal benefit of an extra diamond is high.
4. Principle of Incentive People respond to incentives
Incentive is something that induces a person to act [by offering rewards to people who
change their behavior]. Because rational people make decisions by comparing costs and
benefits, they respond to incentives. Incentives may possess a negative or a positive intention.
It may be in a positive or a negative way.
For example, by offering a raise in the salary of whosoever works harder can induce people
to work hard which is a positive incentive. Whereas putting a tax on a good, say fuel, can
induce people to consume it less which is a negative incentive.

Inductive and Deductive method of Study in Economics

Mathematical tools used in Microeconomics
List of mathematical tools used in economics: 1. Variable 2. Function 3. Equation of a
Straight Line 4. Slope of a Line
1. Variables
Theories in economic analysis explain various economic problems by establishing
relationships between economic variables. In other words, they model the relationships
between two or more economic variables. In establishing such relationships, they apply
numerous mathematical tools such as functions, equations, graphs, calculus, algebra,
derivatives, etc., in order to quantify the facts.
In modelling the relationship between variables, some of the variables are explained within
the theory and their values are dependent on the variables within the model itself. These
variables are called endogenous variables. There are other variables outside the model that
can have an influence on the variables in the model. These variables are called exogenous
variables. The values of the exogenous variables are not dependent on the variables in the
model. They are determined by factors outside the model. For instance, while modelling the
demand for a commodity, price is an endogenous variable that influences the demand for the
product. Other variables such as income of the consumers, tastes and preferences, etc., are all
exogenous variables since they are not influenced by the variables in the model.
D=f(P)
D=f(TFP, Pr, FE, T…n)
2. Function:
X=2(Y)
Economic models establish relationship between two or more economic variables. Such
relationships may sometimes be expressed in the form of a function. A function is an
expression of the relationship between two or more variables. A demand function is
expressed as Qd = f(2P), where Qd represents the quantity demanded, P is the price of the
commodity and ‘f’ represents the functional relationship. It is read as “quantity demanded is a
function of price”.
3. Equation of a Straight Line:
Equations are tools that are used to express the functional relationship between the variables.
The demand function, for instance, is expressed in the form of an equation as-
Qd = a-bP
D=10-2(1)
D=10-2(2)
D=10-2(3)

In the above equation ‘a’ is the intercept which is independent of the change in price. It
shows the quantity of a commodity which will be demanded when the price is zero.
Similarly, ‘b’ is the rate of change which shows by how much the quantity demanded would
change for a unit change in the price of the commodity. So ‘b’ is the coefficient of price.
The functional relationship between variables may be linear or non-linear. In a linear
relationship, the ratio of change in the dependent variable to the change in the independent
variable is constant.
When the relationship is linear, the graph representing the relationship would be a straight
line as shown below:

When the relationship is non-linear, the graph showing the relationship between the variables
would be a curve. When the ratio of change in the dependent variable to the change in the
independent variable is not constant, then the line showing the relationship between the
dependent and the independent variable would be a non-linear curve, as shown below-

4. Slope of a Line:
The slope of a line is an important feature in studying the relationship between variables. It
shows the rate of change in the dependent variable as the independent variable changes. The
demand equation Qd = a- bP is a linear function, where b represents the slope of the demand
curve. When b is negative, the line slopes down from left to right and when b is positive, the
line slopes up from left to right.
The slope of a line is the ratio of change in the dependent variable to the change in the
independent variable.
It is mathematically expressed as:
Consider the demand equation, Qd = 25 – 2P. Here, 25 is the Y intercept, which shows the
demand that is independent of the price and – 2 is the coefficient of price, which indicates
that for a unit increase in the price, the quantity demanded would fall by 2 units.
Consider the supply equation, Qs = 25 + 2P. Here, + 2 is the coefficient of price and is
positive. Thus, a unit increase in the price of the commodity would increase the quantity
supplied by 2 units.
When the equation of a curve is known, it helps in predicting one variable when the other
variable is given.