MICROECONOMICS

Aim of the Course:

• To expose students to concepts and theories that are useful
in understanding, explaining and making predictions
regarding the behaviour of economic agents.

Introduction
• The whole of economics is customarily divided into two
sections to facilitate learning: Micro and Macro economics.

• In truth, the economic universe is composed of a spectrum

of problems, with micro-economics falling on one end and
macro-economics on the other end.

• Real world problems always involve some admixture of micro

and macro economic elements.
The Scope of Micro Economics
• Micro economics studies the economic actions of a particular
individual and a well defined group of individuals (i.e.
households, firms, industries, consumers etc.)

In other words, it studies the economic behaviour of individual

decision making units.
 
• All micro economic decisions are made ultimately by individuals
and the totality of these decisions define the economic
environment
(e.g. consumers decide what and how much of the various
goods to purchase, workers decide what jobs to undertake etc).

• Micro economics is also known as partial analysis since it is the

partial differentiation of the total (Macro).
• According to Prof. Lerner, “Micro economics consists of looking at the
economy through a microscope, as it were, to see how the millions of
cells in the body economic behave.”
 
• The individuals or households as consumers and the individual or firms
as producers – play their part in the working of the whole economic
organism.
(e.g. in micro economic analysis, we study the demand of individual
consumer for a good and from there go on to derive the group demand
for a good).

• Micro economics encompasses the factors that influence the choices

/decisions of individual economic units and the way these innumerable
small decisions merge to determine the workings of the entire economy.
 
• Because of the important effects that prices have on these individual
decisions, micro economics is frequently called “Price theory”.
Types of Micro Economics
1. Simple micro-statics.
• It studies different micro economics variables and their
relationships at a given point in time under the conditions of
equilibrium.
• It therefore assumes that the values of these variables will
remain unchanged.
• Therefore a simple micro-static model does not involve time
period.
D S

As long as the demand and supply functions remain unchanged,

Pe e the price wil stick to Pe

• Micro statics discusses the question of how equilibrium is arrived at

in a market where demand and supply are known and remain unchanged.
2. Comparative micro-statics.
• It compares the equilibrium positions at different points of
time.
e.g. Due to a change in demand, the demand curve shifts, and a new state of equilibrium is reached,
giving a new price.
D2 S
D1 e2
e1

• Comparative micro-statics compares the two equilibrium

positions.
• However, it doesn't throw light on the process by which the
new equilibrium has been arrived at.
3. Micro dynamics (The Cobweb Model)
• This throws full light on the happenings in the market during the
period of transition from one static equilibrium to another.

• It is a study of disequilibrium. Specifically it studies the process

through which the new equilibrium in the market is established.

• The cobweb model is used to explain the dynamics of

demand, supply and price over long periods of time.

(As prices move up and down in cycles, quantities produced also

seem to move up and down in a counter cycle manner).
• We assume that consumers respond to the current market prices, but
suppliers must respond only to what they expect the market price to be.
• Suppliers always expect the price in period t-1 to prevail in period t.

D S
P0
P2

P3
P1

q2 q 3 q1

 Initially price is set at Po, and this price dictates what will be produced in period 1 (q1).
 Demanders will establish the price for period 1 at P1.
 The new price is used in firm’s decisions to produce q2.
 Then demanders set the price at p2. And the process continues.
 Eventually price works its way towards the equilibrium.
 COBWEB MODEL

Assumptions of the cob-web model:

1)There is an immediate response of demand to changes in price: (i.e. current
demand depends on current price).

2)Supply responds to changes in price after a time lag: (i.e. quantity supplied at
current period (t) depends on prevailing price in the previous period (t-1)).

3)We assume that despite the supply time lag, the market will clear at any time
t.

4)Assume that the price and quantity at any time t will not be the same as those at the ideal
equilibrium position.

and
• Let at the ideal equilibrium, quantity demanded equal to
quantity supplied.
Q    aP    bP ........................(i )

• Equilibrium at time t (current period) is given by:

Deriving the general cobweb model:

• Here we try to answer the question “what is the time path
the price must follow in order to achieve the ideal dynamic
equilibrium?”
• In other words, we are supposed to establish an equation
that will enable us to find the price at any time between
initial and new equilibrium positions.
• Subtract equation (i) from (ii):

• …………… (iii)

• Let the difference between the ideal equilibrium

values of price and quantity be denoted by small
letters:
…….(iv)
……(v)
• Using equations (iv) and (v), equation (iii) becomes:

……….. (vi) cobweb model

• Equation (vi) shows the time path the price will follow
towards the ideal equilibrium.
 ɑ is the slope of the demand curve.
 b is the slope of the supply curve.
 If (ɑ > b) then it is a divergent or explosive cobweb.
• This means that the ideal equilibrium is never attainable.
• The real price will go on diverging further and further from the
ideal equilibrium position. (unstable equilibrium).

 If (ɑ < b) then it is a convergent cobweb.

• It means that the ideal equilibrium is attainable. (stable
equilibrium)

 If (ɑ = b) then it is a regular cobweb.

• Here the ideal equilibrium is not attainable.
• The price will oscillate around the ideal equilibrium position
without ever reaching there. (neutral equilibrium)
divergent or explosive cobweb convergent cobweb

regular cobweb
Limitations of the Cobweb model
i. Producers always think that their plans will be fulfilled, which
is not always the case.

ii. The supply curve determines the relationship between ruling

price in current period and quantity supplied in the next
period, which is not always the case.

iii. There is a tendency of thinking that the price of this year has
no effect on this year’s supply, which is not always the case.

iv. It is said that the demand curve shows the relationship

between the ruling price in any year and the quantity
demanded, which is not always the case.
The Nature and Role of Theory
• A theory is a hypothesis that has been successfully tested.
• A hypothesis is tested by its ability to predict accurately and
explain, and also by showing that the outcome follows logically
and directly from the assumptions.
• A theory expresses a casual relationship between sets of
phenomena, one as a cause and the other as effect.
• Economic theory or laws represent certain economic tendencies
or principles expressing what is likely to happen, other things
being equal.
(The phrase “other things being equal” indicates the limitations
within which many, if not all, economic laws operate).
• The purpose of theory is to predict and explain. A theory’s
usefulness depends upon how well we can predict from it and
how important the hypotheses are to us.
Characteristics of Economic Theories
1. Theory as generalization.
• Economic theories are generalizations because their
conclusions are subject to exceptions and are often tolerably
accurate. (hence the phrase “other things being equal”)

2. Theory as Abstraction.
• Theories are necessarily abstractions. A theory is useful
because it tries to eliminate some of the secondary features of
reality so as to highlight the essential characteristics.

3. Amenable to Mathematical and Graphical Techniques.

• It is often possible to express many economic theories
graphically, using coordinate geometry.
Applications and Uses of Economics Theories.
1. To provide tools of economic analysis. Economic theories
provide economic tools to the economists by which they analyse
the economic problems.
 
2. Interpretation of economic phenomena of the real world.
Theories can also suggest solutions to the prevailing problems in
various countries.

3. Basis for predicting unobserved economic events. Economic

theories may explore the economic problems of the real world.

4. Formulation of economic polices.

5. Judging the performance of the economy.

POSITIVE ANALYSIS AND NORMATIVE (VALUE JUDGEMENT)
1. Positive economics deals with or studies ‘what is’ or how the
economic problems facing a society are actually solved.
• It is the study of how the economic system actually functions. It
is concerned with reality.
•  It involves the expected outcomes.
• It deals with prepositions that can be tested with respect to
both their underlying logic and the empirical evidence.
 
2. Normative economics deals with “what ought to be” or how
the economic problems facing the society should be solved.
• It is concerned with the ideal as distinguished from the actual.
• It compares the actual economy with the ideal economy and
the differences between the two lead to economic policy
proposals for improving the performance of the economy.
• Basically microeconomic theory is a form of positive analysis,
(because it draws an accepted standard of logic and evidence that
are potentially capable of being used to ascertain the truth or
falsity of statements)
 
• Normative of value judgement considers the qualitative
terms of a given policy.
- By nature, such a judgement is non-scientific.
- It cannot be proved to be right or wrong by facts, evidence or
logic.

(e.g. a belief that it is desirable to help unskilled workers at the

expense of others falls into this category. People may agree or
disagree. Their value judgements differ)
 
Example:
• Suppose that a firm pollutes the air in the process of
producing its output.

• If we study how much additional cleaning cost is imposed on

the community by this pollution, we are dealing with positive
economics.

• Suppose the firm threatens to move out rather than pay for
installing antipollution equipment. The community must then
decide whether it will allow the firm to continue to operate
and pollute, pay for the antipollution equipment itself, or just
force the firm out with a resulting loss of jobs. In reaching
these decisions, the community is dealing with normative
economics.