INTRODUCTION TO

MICROECONOMICS

CHAPTER 1 INTROD.
1.1 ECONOMICS DEFINED
 Economics has been defined differently by
various scholars
 Adam Smith (1776) defined “economics as an
enquiry into the nature and causes of the wealth
of the nations”.
 Alfred Marshall (1922) defined economics as” the
study of mankind in the ordinary business of life.
 Lionel Robbins (1932) viewed economics as the
science that studies human behavior as a
relationship ends and scarce means that have
alternative uses.
Economics definition cont…
 The Robinn’s definition of economics will be
referred in the entire course.
 Given the economic behavior among
individuals, the basic function of economics
is to observe, explain and predict how
producers choose the best use of their
resources to maximize their income at one
hand; and how consumers decide to spend
their income to maximize their utility.
Economics definition cont…
 From economics point of view, people are classified based
on their decision making position: individuals,
households, firms, government etc.
 As consumers, individuals and households with their given
income have to decide on what to consume and how much
to consume. This is because consumers are utility
maximizers.
 As producers; firms, farms, factories, shopkeepers, banks
etc have to decide on what to produce and how much to
produce to maximize gains/profits in their undertakings.
 Government has to choose how to tax, whom to tax, how
much to spend and how much to spend that social welfare
is maximized.
1.2 Economic concepts
 Scarcity: Nature doesn’t provide as much as everything people
wants.
 Resources are factors employed in the production of goods and
services needed by human being: land, labour, capital and
entrepreneurship
 Land: refers to things that are employed into production of
goods and services that are provided by nature:mineral
deposits, topography, water, vegetation.
 Labour: The mental and physical work offered by human being
in manipulation/production of goods and services
 Capital: All manufactured resources that includes buildings,
machines etc.
 Entrepreneurship: Human activity of rising capital organizing,
managing and assembling of other factors of production
1.3 The scope of economics

 The scope of economics is very

vast. However, it provides
 logic and reasoning
 tools and techniques for analyzing

economic phenomena
 And to predict the consequences

of change of economic phenomena

Scope of economics cont…
 The positive economics studies the
phenomena as they are.
 It seeks to analyze systematically and explain

the phenomena as they actually happen; and

find common characteristics of economic
events, brings out the ‘causal and effect’
relationship between the economic variables
and generalize this relationship in the form of
theoretical
Scope of economics cont…
 Normative economics examines what actually
happens from moral and ethical point of view
and judge whether ‘what happens’ is socially
desirable. It entails answering questions like
‘what ought to be?’ and whether ‘what
happens’ is good or bad from society’s point
of view.
Scope of economics cont…
 Microeconomics is concerned with study of various
individual elements of economic system:
consumer/producer and individual economic
variables.
 It deals with how consumers and producers make
their choices, how their choices affect market
demand and supply conditions.
 Macroeconomics studies the working and
performance of the economy as the whole. It
analyses behavior of the national aggregates:
national income, aggregate consumption,
investment, total employment etc.
1.4 Methodology of economics

 The basic function of economists is to

observe and analyze economic phenomena
and to formulate economic theories.
 This process involves scientific investigation

that lead to model building.

Economic method cont…
 The model building and theorization consists
of the following steps:
 Specifying the problem of the study
 Formulating a testable hypothesis
 Specifying assumptions
 Collection of related data and facts
 Deducing the testable predictions
 Testing the validity of predictions
Methods cont…
 Economic methods are the principles
underlying the economic reasoning. However,
economic models illustrate how economic
world works. The methods are concerned
with scientific explanation of economics and
relations between different economic factors.
Main methods in are experimental,
mathematical, economic framework and
comparative statics.
Economc method cont…
 Experimental economic methods involve
application of economic data to test the
validity of statements related to future
economic developments
 Mathematical economic methods entail use of

mathematics in calculating economic

variables. The method embraces a huge
variety of mathematical equations that aim to
determine the current and future state of an
economy
Economic method cont…
 Comparative statics refers to the economic
method which compares two economic
outcomes before and after a change in the
economy.
 The economic framework is a main method

used for economic studies. It provides

distinction between certain areas of
economics
Economic method cont….
 Generally, economic theories derive laws or
generalizations through two methods:
Deductive Method and Inductive Method.
These two ways of deriving economic
generalizations are now explained in brief.
 Deductive method is also known as analytical,

abstract or prior method. The method derives

conclusions from general truths. It takes few
general principles and applies them to draw
conclusions
Economic method cont…
 Inductive Method involves the process of
reasoning from particular facts to general
principle. This method derives economic
generalizations the basis of (1)
Experimentations (2) Observations and (3)
Statistical ‘methods. The facts are
systematically arranged and the general
conclusions are drawn from them.
Module two: The economy
 In the preceding module we have noted that
economics is the study of economic behavior
and its consequences.
 An economy is a complex system in which

people (economic players) undertake several

and various activities.
The economy cont…
 Buyers and sellers in shops are buying and
selling goods
 Some people are busy in transporting people

from one point to another

 Some people are busy in offices in finalizing

their deals and recording transactions

 Some people are busy in farms producing and

harvesting different commodities

The economy cont…
 an economy can be defined as a social
organism in which economic players act,
interact, cooperate and compete in the
process of production and consumption to
make a living.
 Economic players includes: individuals,

households, firms, farms, factories, financial

institutions and government.
2.1 Simple economy model
 Two major decision makers in a economy
model are households and business firms.
Households play two major roles in the
economic system
 Households supply factors of production:

land, labour and capital to business firms

 Households consume goods and services

produced by business firms

Simple economy model
 On the other hand, business firms are engaged in
the production and distribution of goods and
services.
 The business firms include all firms, farms,

factories and shops. The business firms perform

two major functions in the economic system
 They hire factors of production from the

households and transform them into final goods

and services
 They supply all goods and services to

households, consumers
Simple economy model cont…

Finished products
Goods and
services
market
Pays for goods receives
and services income for goods
and services

Households Firms

Households receives firms pays for factors

Income for factors of production
production

Factor markets

factors of production: labour, capital, land

Simple economy model cont…
 In goods and services, households buy finished
products from firms that are looking to sell what they
make. With this aspect, money flows from households to
firms. The money flow is represented in the inner lines
of the circle.
 Finished products flow from firms to households in the
goods and services markets. The goods and services
flow is represented by outer arrows on the finished
products line.
 The facts that money lines and product lines move in
opposite directions present the facts that economic
players always exchange money for goods and services.
2.2 Production possibility frontiers

 Production possibility frontier refer to the

alternative combination of goods and services
that an economy (normally a nation) is
capable to produce with its given resources
and state of technology
 Take an example of an economy producing

two goods: food and clothing. From this

perspective, production possibility frontier is
the alternative combination of maximum food
and clothing that and
 Production possibility frontier cont…
Table 1: Alternative production possibilities of food and cloth
Alternative Food ( thousand tons) Clothing (million metres)
P 8 0
A 7 40
B 6 55
C 4 64
D 5 71
E 3 76
F 0 80
Production possibility frontier cont…
Production possibility frontier cont…
 The curve is referred to production possibility
frontier (PPF). It shows all alternative
combination of two goods (food and clothing)
that can be produced by making full use of all
of the available resources (labour and capital)
with a given state of technology
2.3 opportunity cost
 Opportunity cost is the benefit that is
foregone to attain the benefit of another
opportunity.
 The opportunity cost of an increase in the

output of some product is the value of the

other goods and services that must be
foregone when inputs (resources) are taken
away from production in order to increase the
output of the product in question.
MODULE 3: THEORY OF
CONSUMER BEHAVIOUR
3.1:Cardinal utility approach (Marshallian
approach)

 A consumer is a utility maximizing entity

 All consumption decisions are directed
towards maximization of total utility.
 Utility refers to the power of property of a

commodity to satisfy human needs

 Food satisfy hunger
 Water quenches thirsty
3.1.2 Measurability of utility

 The utility was measured quantitatively in

absolute terms such as meter, kilogram, etc
 Util is a measure of utility; and equals to the

price that consumer pays for a commodity

 Marginal utility of money remains constant
3.1.3 Total and marginal utility

 TU refers to the sum of the utility derived

from all units of commodity consumed.
 Total utility (TU) = U + U + U …………… (1)
1 2 3
 TU = = U + U + U + …… + U …………. (2)
1 2 3 n
 Marginal utility is the utility derived from the

marginal/last unit of commodity consumed.

 It is the addition to the total utility derived

from consumption/acquisition of one

additional unit.
Total and marginal utility cont…
 MU = ∆TU ……………………. (3)
∆Q
 Whereby, ∆TU – the change in total utility, ∆Q is the
change in quantity of a commodity consumed.

 MU = TUn – TUn-1 ………………………………… (4)

3.1.4 The law of diminishing marginal utility

 The law of diminishing marginal utility states

that ‘as the quantity of a commodity
consumed increases per unit time, the utility
derived from consumption of successive units
of a commodity decreases given that
consumption of all other goods remains
constant’.
 Table 1 portrays the numerical illustration of

the law of diminishing marginal utility

Law of diminishing marginal returns
cont…
Table2 : Diminishing marginal utility from successive units of beers consumed
Bottles of beers consumed Total utility Marginal utility
0 0 0-0 = 0
1 30 30 – 0 = 30
2 50 50 – 30 = 20
3 60 60 – 50 = 10
4 65 65 – 60 = 5
5 66 66 – 65 = 1
6 60 60 – 66 = -6
Law of diminishing marginal returns
cont…
 Total utility increases with increase in
consumption of commodities at a decreasing
rate
 This imply that MU decreases with increase in

consumption
 Consumption of the sixth bottle of beer

yields a negative marginal utility hence TU

declines.
Law of diminishing marginal returns
cont…
Assumptions of diminishing marginal utility

 The unit of a commodity consumed must be

standard
 Consumers’ preferences remain unchanged

during the time of consumption

 There must be continuity in consumption
 The consumer is of sound mind during the

consumption
3.1.4 Consumer equilibrium

 Assumptions underlying consumer

equilibrium state
 Rationality
 Limited income:
 Maximization of satisfaction
 Utility is cardinally measurable
 Diminishing marginal utility
 Constant utility of money
 Utility is additive
 TU = U1(Q1,) + U2 (Q2) + U3 (Q3) + .. + Un (Qn) …...(6)
3.1.5.1 Consumer equilibrium with a one commodity case

 Assume that a consumer with income

consumes only one commodity X.
 If consumer holds his total income, (MU ) >
x
(MUm)
 In that case the total utility can be

exchanging money for the commodity.

 Hence a utility maximizing consumer

exchanges his money income for the

commodity as long as MUx > MUm
Consumer equilibrium cont…
 MUx ⇩; while MUm is constant
 Hence a consumer exchanges his money for
commodity X as long as as MUx > Px(MUm)
 The utility maximizing consumer reaches at
equilibrium (i.e reaches his maximum
satisfaction when
 MUx = Px(MUm) ……………………………… (7)

 _MUx__ = 1 ………………………………… (8)

 Px(MUm)
Consumer equilibrium cont…
The single case equilibrium state is illustrated
graphically in figure 3 showing
 The constant utility of money weighed by P
x,
the price of commodity X and MUx curve
representing diminishing marginal utility of a
commodity X.
Consumer equilibrium cont…
Consumer equilibrium cont…
 Px (MUm) line and MUx curve intersect at point
E; where MUx = Px (MUm) hence a consumer is
at equilibrium at this point E.
 At any point above E, MU >P (MU );
x x m
therefore if consumer exchanges his money
for commodity X, he increases his satisfaction
 At any point below E, MU < P (MU ); the
x x m
consumer can increase his satisfaction by
reducing his consumption
3.1.5.2 Consumer equilibrium with two commodity case

 In reality individuals consume large numbers

of goods.
 A rational utility maximizing consumer picks

up first the commodity that yield him the

highest utility, … until the commodity that
yield the least utility.
 The consumer switches his expenditure from

one commodity to another until he reaches a

stage where MU of each commodity is the
same per unit of expenditure.
Consumer equilibrium cont…
 From the single commodity case, the
consumer switches his income between
commodities X and Y so that

MUx = Px (MUm)
(9) ……..……………………………………………….. ൜
MUy = Py(MUm)
Consumer equilibrium cont…
 OR
MUx MUx
(10) …………….…………………………….. ൝ _________ = 1; _________ =1
Px(MUm) Px(MUm)
Consumer equilibrium cont…
 Equation 9 and 10 can be written together in
equilibrium conditions as follows

MUx MUy
_________ = 1 = _________ …………………………………………………………….. (11)
Px(MUm) Py(MUm)

OR
𝑀𝑈𝑥 𝑃𝑥 (𝑀𝑈𝑚 )
= ………………………………………………………………………. (12)
𝑀𝑈𝑦 𝑃𝑦 (𝑀𝑈𝑚 )
Consumer equilibrium cont…

𝑀𝑈𝑥 𝑃𝑥
= ………………………………………………………………………….. (13)
𝑀𝑈𝑦 𝑃𝑦

OR
𝑀𝑈𝑥 𝑀𝑈𝑦
= ………………………………………………………………………... (14)
𝑃𝑥 𝑃𝑦
Consumer equilibrium cont…
 Equation 14 concludes that the consumer
reaches his equilibrium when the MU derived
from each shilling spent on the two
commodities is the same.
3.5.3 The general case equilibrium state

 The two commodity case provides the basis

for generalizing consumer’s equilibrium. An
individual consuming A to Z commodities, his
equilibrium condition can be expressed as
𝑀𝑈𝑎 𝑀𝑈𝑏 𝑀𝑈𝑐 𝑀𝑈𝑧
𝑃𝑎
= 𝑃𝑏 = 𝑃𝑐 = …………………… 𝑃𝑧 ; …………………………………. (15)
3.6 Weaknesses of cardinal utility
curve approach
 The assumption that utility can be measured
in absolute terms is unternable
 Unrealistic assumption of constant utility of

money
 The law of Diminishing marginal utility has

been accepted without empirical verication

 Cardinal utility approach is based on the

ceteris paribus assumption which is

unrealistic in practical sence
 MODULE 4
THEORY OF CONSUMER BEHAVIOR:
ORDINAL UTILITY APPROACH
(INDIFFERENCE CURVE ANALYSIS)
Indifference curves introduced
 The ordinal utility approach assumes that
utility cannot be measured in absolute terms,
it can only be represented in ordinal way such
that consumer should be able to rank his
order of preferences over commodities
consumed
4.1 Assumptions of ordinal utility
theory
 Rationality:
 Ordinal utility
 Transitivity of choice: if consumer prefers A to B,
and B to C; then he must prefer A to C
 Consistency: If consumer prefers A to B in one
period, he will not prefer B to A in another period.
 Nonsatiety: Consumer prefers more than less
commodities
 Diminishing marginal rate of substitution: ∆Y/∆X
goes on decreasing when a consumer continues
to substitute X for Y
4.2 Indifference curve defined and
nature of indifference curves
 An indifference curve refers to a locus of
points each representing different
combinations of two goods but yielding the
same level of satisfaction (utility).
Indifference curve defined cont…
 The X and Y axes is known as indifference plane
or commodity space.
 This plane is full of finite points and each point

on the plane indicates different combination of

good X and good Y.
 Location of any two or more points that indicate

different combinations of good X and good Y that

yield the same satisfaction is possible
 Therefore, several indifference curves can be

drawn on the same plane. These are known as

indifference map.
Indifference curve defined cont…
Diminishing marginal rate of substitution (MRS)

 When a consumer makes different

combination of two goods that yield the same
level of satisfaction, he substitutes one good
for another.
 The rate at which he substitutes one good for

another is called ‘marginal rate of

substitution’
 The ordinal utility approach assumes that

MRS decreases along the indifference curve

4.3.1Measuring marginal rate of substitution (MRS)

 Marginal rate of substitution is the rate at

which one commodity can be substituted for
another keeping the same level of
satisfaction.
 Symbolically, the MRS concepts is given by a

utility function of a consumer such that

U = f (X,Y) ……………………………………………………………………………. (4.1)

Measuring MRS cont…
 Let us think that consumer substitutes X for
Y. when the consumer foregoes some units of
Y his stock of decreases by -∆Y.
 This loss of utility is quantified as -∆Y*MU .
y
 On the other hand, as a result of substitution
his stock of X increases by +∆X. The
increased utility from ∆X equals to +∆X*MUx.
 For the total utility to remain the same,
-∆Y*MUy must be equal to +∆X*MUx
-∆Y*MUy = +∆X*MUx ………………………………………………………….. (4.2)
Measuring MRS cont…
 Rearranging terms in equation 4.2, we have
equation 4.3

-∆Y = MUx ………………………………………………………………….. (4.3)

∆X MUy
 Here, the ∆Y/∆X is simple the slope of
indifference curve that gives the MRSx,y when
X is substituted for Y. Similarly the ∆X/∆Y
gives MRSy,x when Y is substituted for X
Measuring MRS cont…
 Therefore;

MRSx,y = -∆Y = MUx

∆X MUy

MRSy,x = -∆X = MUy

∆Y MUx
4.3.2 The diminishing MRS

 The ordinal approach assumes that MRSx,y or

MRSy,x decreases along the indifference curve.
 Table 3 shows the MRSx,y obtained when
consumer moves from point a to b on the
indifference curve.
 The diminishing rate of substitution causes

the indifference curves to be convex to the

origin
Diminishing MRS cont…
Table 4.1 Diminishing marginal utility
Movement on IC ∆Y ∆X MRSy,x
From point a to b -10 2 -5
From point b to c -5 5 -1
From point c to d -4 8 -0.5
From point d to e -2 10 -0.2
Diminishing MRS cont…
 Graphically, it is demonstrates as follows
Diminishing MRS cont…
 As consumer moves from point a to b, from point
b to c and from c to d he gives up a constant
quantity of Y ie ∆Y1 = ∆Y2 = ∆Y3.
 To substitute a constant quantity of ∆Y he
requires an increasing quantity of ∆X. i.e. ∆X1 <
∆X2 < ∆X3
 Since MRS = ∆Y/∆X;
 ∆Y1/∆X1 > ∆Y2/∆X2 >∆Y3/∆X3
 These inequalities show that MRS (∆Y/∆X)
decreases as consumer moves along the
indifference curve
4.3.4 Why does MRS diminish
 The negative slope of indifference curve
indicates that two commodities are not
perfect substitutes
 The subjective value attached to the

additional quantities (MU) of a commodity

decreases fast in relations to the other
commodity whose total quantity is decreasing
4.4 Properties of indifference
curves
 Indifference curves have a negative slope. The
negative slope of indifference curve indicates that
(a) the two commodities can be substituted for
each other and (b) if quantity of one commodity
decreases; quantity of another commodity must
increase to stay in the same level of satisfaction
 Indifference curves are convex to the origin. This

implies that two commodities are not perfect

substitutes for each other; MRS between the two
goods decreases as consumer moves along the
indifference curve
Properties of IC cont…
 Indifference curves do not intersect nor be
tangent to each other. If two indifference
curves intersect, this would imply that an
indifference curve indicates two different
levels of satisfaction; or two different
combinations (one being larger than the
other) yield the same level of satisfaction.
Therefore, this would violate the transitivity
rule
Properties of IC cont…
Properties of IC cont…
 Upper indifference curves indicate a higher
utility levels than the lower ones. An IC placed
above and to the right of another represents a
higher level of satisfaction than the lower one.
 This is because the upper indifference curve
contains a larger quantity of one or both the
goods than the lower indifference curves.
 And a large quantity of a commodity is
supposed to yield greater satisfaction than the
smaller quantity of it provided that MU > 0
Properties of IC cont…
Properties of IC cont…
 The vertical movement from point e in the
lower IC1 to the point b on the upper
indifference curve IC2 means the increase of
quantity of Y by eb, the quantity of X (OX)
remaining the same.
 The horizontal movement from point e to d

means a greater quantity of commodity X,

while quantity of Y remaining the same.
 The diagonal movement of from e to c,

means larger quantities of both X and Y.

4.5 The budget constraint and budget line

 The consumer intends to reach the highest IC

 However, he is constrained by a limited

income.
 Assuming the two commodity model; the

budgetary constraint can be represented by



PxQx + PyQy = M ……………………………………………………………………………………………………… (4.4)

 To derive the maximum quantity of X and Y
consumed;
 It is assumed that the whole of the income is

either spent on X or on Y.
 By joining the two points on the X, Y plane,

the budgetary constrain is represented as

figure 8.
 If the whole income is either spent on X or Y,
the quantities of X and Y consumed are
presented in eqn 4.5 and 4.6 respectively

Qx = M/Px …………………………………………………………………………………………………..4.5; and

Qy = M/Py …………………………………………………………………………………………………..4.6
 Graphically, this can be presented as in figure
8
4.5.1 Shifts in budget line

 The budget line changes its position

following changes in consumer’s income and
commodity prices.
 The budget line changes its position

following changes in consumer’s income and

commodity prices. If consumer’s income
increases while the prices of commodity X
and Y remain the same; the budget line shifts
upward remaining parallel to the original
budget line
Shifting of budget line cont…
 If prices of commodities change while income
remaining the same, the budget line changes
its position.
 For example if M and P remain the same and
y
Px decreases the point B will shift to point F
and the budget line will shift to AF.
 Similarly if M and P remain the same if P
x y
increases the budget line shifts to EB.
Shifting of budget line cont…
4.5.2 Slope of the budget line

 The slope of budget line is given by ∆Qy/∆Qx

= OA/OB as indicated in figure 10.
 Since OA = M/P and OB = M/P , the slope of
y X
the budge line can be written as

OA = M/Py = Py ……………………………………………………………………….. (4.7)

OB M/PX PX
Slope of indifference curve cont…
4.6 Consumer’s equilibrium

 Consumer attains her equilibrium when he

maximizes his total utility, given his income
and market prices of goods and services he
consumes.
 Under indifference curve analysis of

consumer behavior necessary condition for

total utility to be maximum is that MRS must
be equal to price ratios of commodities
consumed.
Consumer’s equilibrium cont…
 The consumer’s equilibrium is graphically
illustrated in figure 10 showing the
indifference map with IC1, IC2 and IC3 curves.
 The consumer is at equilibrium at point E
where indifference curves IC2 is tangent to
the budget line AB. At this point, the slope of
IC2 and the slope of budget line AB are equal.
  
Consumer equilibrium cont…