Micro Economic Analysis

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 Introduction
• Economics is a science which studies human behaviour as a
relationship between ends and scarce means which have alternative
uses (Lionel Robbins)

• Economics is a study of mankind in the ordinary business of life and

examines that part of individual and social action which is connected
with material requisites of wellbeing. (Alfred Marshall)

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 Introduction
• The word ‘economy’ comes from two Greek words – oikos (meaning house)
and nemein (meaning manage) – its original meaning was ‘household
management’.

• Households have limited resources and managing these resources requires

many decisions and a certain organisational system.

• The meaning of the word economics has developed over time. Today,
economics can be defined as the study of how societies make choices on
what, how and for whom to produce, given the limited resources available to
them.
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 Rationality
• Rational choice theory thinks of people as not just as narrowly
rational, but as economic super-men and women—sometimes called
homo economicus. Economists using rational choice theory think
about what ‘economic man’ would do and then add up the actions of
billions of ‘economic men and women’ to make models, or simplified
stories about how the economy works

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Bounded Rationality

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 Fundamental Problem of Economics
• The study of the optimal use of scarce resources to satisfy unlimited
wants (Lionel Robbins, 1932)

• Human wants are unlimited

• Resources available to satisfy these wants are scarce / limited

• People want to maximize their gains

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 Fundamental Problem of Economics
• Economic agents / society have some economic problems because of
scarcity of resources

• They need to choose scarce resources among alternatives (scarce

resources) based on choice and valuation of alternatives

• Thus economics is the study of how economic agents or societies

choose to use scarce productive resources that have alternative uses to
satisfy wants (needs) which are unlimited and of varying degree of
importance
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 Scarcity and Choice
• Because we “can’t have it all”, we must decide what we will have and
what we will forgo.

• At the core of the economics is the idea that “there is no free lunch”.

• You might have a free lunch, but society bears the cost and the inputs
used could have been used to produce something else.

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 Opportunity cost
Opportunity cost is the value of something when a particular course of
action is chosen. Simply put, opportunity cost is what you must forgo
in order to get something.

The benefit or value that was given up can refer to decisions in your
personal life, in a company, in the economy, in the environment, or on
a governmental level.

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 Micro Economics
• Microeconomics focuses on the actions of individual agents within the
economy, like households, workers, and businesses.

• Microeconomics explains how and why these inputs make economic

decisions. For example, it explains how consumers make purchasing decisions
and how their decisions are affected by changing prices and incomes.

• By contrast, Macroeconomics deals with aggregate economic quantitites, such

as the level and growth of national output, interest rates, unemployment and
inflation.

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 Themes of microeconomics
• Allocation of Scarce resources – Much of microeconomics is about limits – the
limited income that consumers can spend on goods and services, the limited
budgets and technical know-how that firms can use to produce things, the
limited number of hours that the workers can allocate to labour or leisure .

• Trade-offs- (a) Consumers have limited incomes which can be spent on

variety of goods and services or saved for the future. Consumer theory
describes how consumers based on their preferences maximise their well
being by trading off the purchase of some goods for the purchase of less
of others. They also decide how much of their income to save, thereby
trading current consumption for future consumption.
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 Themes of microeconomics
• (b) Workers also face constraints and make trade-offs.

• First, people must decide on when to enter the workforce. Because of the kinds of
jobs and corresponding pay scales- available to a worker depend it part to educational
attainment and corresponding pay scales, one must trade off working now (and
earning an immediate income) or continue the education (with the hope of earning a
higher future income).

• Second, workers face their trade-offs in their choice of employment. For example,
while some people choose to work for large corporations that offer job security, but
limited potential for employment, others prefer to work for small companies where
there is more opportunity for advancement, but less security.
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 Themes of microeconomics
• Firms – Firms face limits in terms of the kind of products that they can produce and
the resource's available to them. For example Tata company must decide how many of
each type of vehicle it wants to produce. The envisaged production targets for the
current year or subsequent years would determine whether to hire more workers,
build new factories or do both.

• Prices and Markets – All of the trade-offs described above are based on the prices
faced by consumers, workers or firms. A consumer trades off cheese for chicken based
partly on his or her preferences for each one, but also on their prices. Likewise,
workers trade off labour for leisure based in part on the “price” they can get for their
labour – i.e, the wage. Firms decide on whether to hire more workers or purchase
more machines based in part on wage rates and machine prices.

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 Themes of microeconomics
• Equilibrium – An equilibrium refers to a condition which is stale and
has no tendency to change. If a person or any economic activity
considers a situation as the “best attainable”, under the prevailing
conditions, it implies that any change from it is undesirable.

• A consumer reaches equilibrium when he consumes the bundle of

goods that maximise his satisfaction, given the price of commodities
and his preferences and income. Similarly, a firm attains equilibrium,
when it maximises profit, given the cost and revenue functions.

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 Theories and models
• Like, any science, economics is concerned with the explanations of observed
phenomena. Why, for example do firms tend to hire or lay off workers when
the prices of their raw materials change?.

• The theory of the firm, for example begins with the simple assumption – firms
try to maximise their profits. The theory uses this assumption to explain how
firms choose the amount of labour, capital and raw materials that they use for
production of ouput.

• A model is a mathematical representation based on economic theory of a

firm, market or any other entity.
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 Production function
• A firm’s long-run production function is of the form:
• Q = f(Ld, L, K, M, T, t)
• where Ld = land and building; L = labour; K = capital; M = materials; T
= technology; and, t = time.
• For sake of convenience, economists have reduced the number of
variables used in a production function to only two: capital (K) and
labour (L).
• Therefore, in the analysis of input-output relations, the production
function is expressed as: Q = f(K, L)

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 Positive versus Normative Analysis
Microeconomics is concerned with both positive and normative questions. Positive
questions deal with explanation and prediction, normative questions with what
ought to be.

Suppose Indian government imposes a quota on import of sugar. What will happen
to the price, production and sales of sugar in the domestic market? What impact
will the policy change on indian consumers? On workers in the sugar industry?
These questions belong to the realm of positive analysis.

Theories are developed not only to explain phenomena, but also to make
predictions.

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 Positive versus Normative Analysis
• The use of economic theory for prediction is important both for the
managers of the firm and for public policy. Suppose, Government of
India is considering raising the tax on petrol. The change would affect
the price of petrol, consumer preferences for small or large cars, the
amount of driving people do and so on.

• Government policy makers would need quantitative estimates of the

effects on consumers (possibly broken down into income categories),
the amount of tax revenue to be collected each year.

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 Positive versus Normative Analysis
• Sometimes, we want to go beyond explanation and prediction to ask
such questions as “what is best”. This involves normative analysis,
which is also important for both managers of firms and those making
public policy. Again consider a new tax on petrol.

• For policy makers, the primary issue is likely to be whether the tax is
in the public interest. The same policy objective (say increase in tax
revenue), might be met more cheaply with a different kind of tax,
such as tariff on imported oil.

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 Positive versus Normative Analysis
• Normative analysis is often supplemented by value judgements. For
example a comparison between a petrol tax and an oil import tariff
might conclude that the petrol tax will be easier to administer, but will
have a greater impact on lower-income consumers.

• At that point, society must make value judgement, weighing equity

against economic efficiency.

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 What is a market?
• A market is the collection of buyers and sellers that through their actual or potential interactions,
determine the price of a product or set of products.

• When defining a market, potential interactions of buyers and sellers can be just as important as
actual ones. An example of this is market for gold. A Singaporean who wants to buy gold is
unlikely to travel to Dubai to do so. Most buyers of gold in Singapore will interact only with sellers
in Singapore. But because of the cost of transporting gold is small relative to its value, buyers of
Gold in Singapore could purchase their gold in Dubai if the prices were significantly lower.

• Significant differences in the price of a commodity creates a potential for arbitrage: buying at a
lower price in one location and selling at a higher somewhere else. The possibility of arbitrage
prevents the prices of gold in Singapore and Dubai from differing significantly and create a world
market for Gold.

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Competitive versus Non-competitive Markets
• A perfectly competitive market has many buyers and sellers, so there is no single
buyer or seller has a significant impact on price. Most agricultural markets are
close to being perfectly competitive. For example there are thousands of
producers who produce wheat and thousands of buyers of wheat, so no single
buyer or seller has a significant impact on the price.

• Non competitive markets are those in which individual firms can jointly affect the
price. The world oil market, since the early 1970s, the market has been
dominated by the OPEC cartel.

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 Utility
• For example, suppose you have just eaten an ice-cream and a
chocolate.

• Can you tell how much are you satisfied from each of these items?
Probably you can tell which item you liked more. But, it is very
difficult to express “how much” you liked one over the other.

• It is evident, that we need a more quantitative measure of satisfaction.

Due to this reason, economists developed the concept of utility.
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 Utility
• We make many decisions to allocate scarce money and time.
• Buy pizza or burger?
• Second hand or first hand car?
• Spend or save?
• Sleep early or work late in the night

• These competing demands and desires and the choices we make define
our lives.

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 Utility
• Utility refers to want satisfying power of a commodity. It is the
satisfaction, actual or expected, derived from the consumption of a
commodity.

• This is based on the premise that people choose those goods and
services they value most highly.

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 How to Measure Utility?

• According to classical economists, utility can be measured, in the

same way, as weight or height is measured.

• For this, economists assumed that utility can be measured in cardinal

(numerical) terms. By using cardinal measure of utility, it is possible
to numerically estimate utility, which a person derives from
consumption of goods and services.

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 Classical economics
• School of economic thought which stresses that economies function
most efficiently if everyone is allowed to pursue his or her self
interest, in an environment of free and open competition.

• Classical economics believes that the economy is self-correcting.

According to Say’s law, supply creates its own demand.

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 How to Measure Utility?

• According to classical economists, utility can be measured, in the

same way, as weight or height is measured.

• For this, economists assumed that utility can be measured in cardinal

(numerical) terms. By using cardinal measure of utility, it is possible
to numerically estimate utility, which a person derives from
consumption of goods and services.

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 Cardinal versus Ordinal Utility
• Cardinal Utility–Satisfaction derived by the consumers from the
consumption of good or service can be expressed numerically.
(Measurement: Utils)

• Ordinal - Ordinal utility states that the satisfaction which a consumer

derives from the consumption of good or service cannot be expressed
in numerical units. (Measurement: Ranking).

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 Marginal and Total utility
• Total utility refers to the total satisfaction received by the consumer from
consuming different units of a commodity while the marginal utility, connotes
the additional utility derived from the consumption of the extra unit of a
commodity.

• From product point of view, Utility refers to the power of a commodity to

satisfy consumer wants.

• While from consumer’s point of view, it is a psychological feeling of

satisfaction or pleasure, which varies from individual to individual, derived by
the consumer on consumption of the good or service.
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 Definition of Total Utility

• The overall satisfaction derived by a consumer from consumption of various units of

a good or service, at a certain point or over a period, is known as total utility or
alternately called as “full satiety.” In simple terms, total utility is nothing but the
aggregate of all marginal utilities of the individual units consumed. In general total
utility increases, with each additional unit consumed. Total Utility can be expressed
as:

• TUn = Ux + Uy + Uz   or TU = ƩMU

• Where TU = Total Utility
n = Number of commodities
Ux , Uy , Uz = Total respective utilities of consumption of goods
MU = Marginal Utility
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 Definition of Marginal Utility
• The term ‘marginal’ refers to small change, and utility means satisfaction. So, as its name suggests
marginal utility is the additional satisfaction received by a consumer, on the consumption of an
extra unit of a commodity. It implies the addition to the total utility, due to the consumption of one
more unit of a good or service. Marginal Utility is also known as “marginal satiety”. It can be
expressed as:

• Where, MU = Marginal Utility

• ∆TUx = Change in Total Utility

∆Qx = Change in quantity consumed by 1 unit.
• Alternative way of expressing marginal utility when (n) is the number of units consumed, can be
given as:
• MU of nth unit = TUn – TUn-1

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Relationship between TU and MU
Units Total Marginal
consumed Utility Utility

1 30 30
2 56 26
3 76 20
4 88 12
5 90 2
6 90 0
7 86 -4
8 78 -8

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Graph

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 Preferences
• The foundation for Economics is rationality. Rationality implies that people will act in ways that
best suit their particular set of circumstances, including, but not limited to, the choices they face.
In order to choose, you must necessarily have a set of preferences over the options you are
presented with.

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 Axioms
• In being rational, and in your decision making on the choices that you make, you must have a set
of preferences over the options that you are presented with.

• The preferences must fulfill a set of criteria.

• The first axiom is Completeness.

• A is preferred to B or B is preferred to A or the consumer is indifferent between A and B

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 Completeness
• That is, whether one is indifferent to, or prefers, one set of options
over another, they must always be able to make that choice.

• That is, a consumer can always rank a set of possibilities as either

better, worse, equal or at least as good/bad as another.

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 Transitivity
• Transitivity – This simply means that consumers are able to order their
preferences in a logical manner.

• - A is preferred to B
• …..Or B offers less utility than A,
• Or A and B are indifferent.
• Or A is at least as good as B.

• And therefore to be transitive, if A is preferred over B and B over C, then A is

preferred over C.

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 Non-satiation
• Non-satiation- for any amount of a good or service, more is preferred
to less.

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 Application of MEA Tools to Natural
Resource Management
• The economic analysis of environmental issues can be approached from two different
(though sometimes overlapping) perspectives, environmental economics and ecological
economics.

• Environmental economics applies insights from traditional economics to environmental

issues.

• Environmental economics: economics that applies the techniques of economic analysis,

such as valuation and cost-benefit analysis, to environmental and resource issues.

• Ecological economics: a economic perspective that views the economic system as a subset
of the broader ecosystem and subject to biophysical laws.

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Total Economic Value

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 Direct use value
• Direct use values refer to ecosystem goods and services that are used directly by
human beings.

• They include the value of consumptive use such as harvesting of food products,
timber for fuel or construction, and medicinal products and hunting of animals
for consumption; and the value of non-consumptive uses such as the enjoyment
of recreational and cultural activities that do not require harvesting of products.

• Direct use values are most often enjoyed by people visiting or residing in the
ecosystem itself.

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 Indirect use values
• Indirect use values are derived from ecosystem services that provide benefits
outside the eco-system itself.

• Examples include the natural water filtration function of wetlands, which often
benefits people far downstream, the storm protection function of coastal
mangrove forests, which benefits coastal properties and infra-structure, and
carbon sequestration, which bene-fits the entire global community by abating
climate change.

• These functions often affect activities that have directly measurable values,
allowing their value to be estimated.

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 Option values
• Option values are derived from preserving the option to use in the
future ecosystem goods and services that may not be used at present,
either by oneself (option value) or by others/heirs (bequest value).

• Provisioning, regulating, and cultural services may all form part of

option value to the extent that they are not used now but may be
used in the future.

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 Services
• Provisioning services are the products directly obtained from ecosystems (e.g., food,
fiber, timber)

• Regulating services are the benefits obtained from the regulation of ecosystem processes
(e.g., climate regulation, water regulation, pest and disease regulation)

• Supporting services are indirect services, as they are necessary for the production of
provisioning, regulating or cultural services (e.g., soil formation, nutrient cycling,
photosynthesis)

• Cultural services are nonmaterial benefits people obtain from ecosystems (e.g., aesthetic
values, recreation and ecotourism, cultural diversity).

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 Existence value

• Definition: Willingness to pay for the existence of an environmental

resource without on-site use. It can be motivated by an ecological
ethic, altruism toward others or bequests to future generations

• The origin of existence value can be traced to John Krutilla who in

1967 proposed that economists should not just assign values to goods
and services that are directly consumed, but should also attribute a
value to the knowledge that a particular wilderness, endangered
species or other object in nature exists

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 Bequest value
• The value that people place on knowing that future generations will
have the option to enjoy a particular environmental asset, which is
usually measured by willingness to pay.

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 Option and Existence Values
• The option value reflects the value of the environment as a potential
source of benefit, in the future, as opposed to actual present use
value. Existence value is the satisfaction people obtain from an
amenity for various reasons other than their expected personal use.

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 Economic theory and the environment
• Standard economic theory demonstrates that under certain
assumptions unregulated markets, guided by the forces of supply and
demand, allocate resources in an efficient manner.

• In other words, market outcomes maximize the net benefits obtained

by buyers and sellers. But when we consider the environmental
impacts of market activity, the conclusion that unregulated outcomes
are efficient is no longer valid

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 Environmental Externalities

• The concept of externalities is central to environmental economics. In economic

terms, a market transaction creates an externality when it impacts someone other
than the buyer and the seller.

• For example, a firm which pollutes a river while manufacturing paper harms those
who use the river for fishing, swimming, or drinking water. This negative
externality might be measured in monetary terms – for example, the lost revenues
of professional fishers. Some damages may be more difficult to measure but no
less important – for example, health costs caused by toxins in the water, or the
loss of enjoyment by those who can no longer swim in the polluted water.

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 Illustration of use of micro economic concepts to
manage environmental issues
• A pollution charge is a tax imposed on the quantity of pollution that a firm emits.
A pollution charge gives a profit-maximizing firm an incentive to figure out ways
to reduce its emissions—as long as the marginal cost of reducing the emissions is
less than the tax.

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Thanks

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