Micro Economics

Term 1
Prof. Sumirtha
Email: Sumirtha@base.ac.in
 Requirements for the Course
Basic Calculus

• Helps us understand the intuition behind mathematics

• Helps in understanding the nature of the graphs

Differentiation and basic geometry

• Concave and convex functions

• First and second order derivative

• Optimization problems – Constrained optimization

 What is the intention of the course?
• How do individuals (managers) make decisions?
• How do firms make decisions?
• Marketing
• Sales (Pricing of goods, elasticity, markets)
• Advertising

• Operations
• Supply chain (Game theory, market structures)

• Finance
• Risk and Uncertainty

• Public Policy
• Policy evaluations, regulations, and externalities
Course Outline (Text book : Pindyck & Rubinfield)
Session Topic Readings
1 Introduction, Demand and Supply Ch 1,2
2-3 Demand & Supply (Contd.) Ch 2

4-6 Elasticity Ch 2 & 4

7-9 Theory of Consumer Choice Ch 3
 Background
What is Economics?: Economics is the study of scarcity and its implications for the use of
resources, production of goods and services, growth of production and welfare over time,
and a great variety of other complex issues of vital concern to society.

What is Micro-economics?: Branch of economics that deals with behaviour of individual

economic units. These units could be consumers, labourers/workers, firms, investors etc

E.g.: Why does one (consumer) go for an iPhone vis-à-vis Android? What is the impact of
changing prices and income on consumption decisions. Firm – How much to produce? What
should be the selling price? How many inputs (machinery, labour etc) to hire. Worker –
Where to work (which company) and how much work to do (labour allocation decision)?
 Background (Contd..)
Objective of micro-economics – Study individual behaviour, helps
understand market and how do markets perform? What is the effect of govt
policies(import duty rise) and global economic conditions (inflation) on
markets of goods?
What is Macro-economics?: Macroeconomics deals with the study of
aggregate economic quantities – Output/GDP, unemployment, inflation etc.
Difference between two branches? Or an extension?
Earlier the two branches were considered distinct. In the recent years, Macro-
economics is considered an extension of micro-economics. Why? The analysis
of aggregate economic quantities is based upon how individual economic
entities behave.
Trade-Offs and Prices
Limits – consumer has limited income (to spend on food v/s clothing), students have
limited time (to allocate between studying, going out, sleeping), firms have limited
resources (to allocate between machinery and other inputs)

Role of micro-economics : How to make most of these limits by allocating scarce

resources like time and money.

 In other words – the subject deals with Trade-offs that economic entity faces and
shows how these trade-offs are best made.
 Trade Offs and Prices (Contd..)
Role of prices – Trade off are based on prices. (consumer – price of Vitos Pizza v/s price
of dominos pizza, workers – price of leisure v/s work (wages), Firm- based on input
prices – decide which inputs to use)

But how are prices determined? (Buyers/demand and Sellers/supply – interaction

between these in a free market determine prices)
 Role of Theories
Tools – Theories of Micro-economics (Consumer theory, Producer Theory, Markets etc)

What is a theory? Theory explains a particular phenomenon (level of output produced

by a firm, units of inputs used) in terms of assumptions (such as firms are profit
maximisers and consumers maximize utility)

Theory can also be used for making predictions (what happens if price of inputs rise,
wages rise etc.)

However theories are imperfect (Why? They are based upon assumptions. But not all
firms might be profit maximisers – e.g. Railways, Electricity Suppliers etc)
 Positive v/s Normative Analysis
Positive analysis (Explanation and predictions: considered so far) – Suppose there is a rise in import
duty of certain goods (mobile phones)- what will happen to retail price? What would happen to
domestic production? What would happen to demand and so on. (Quantify the changes occurring
to producers and consumers) In short, it is analysis of cause and effect.

Normative Analysis – What is best? Considering alternative options (import duty rise vis-à-vis
production linked incentives for domestic production), Balancing of costs and benefits (to find
desirable/optimum imposition of taxes, incentives etc.), Value judgement (which policy is easier to
implement?, Impact on purchasing power of consumers), Helps with trade-off analysis. In short, it is
an analysis that examines questions of what ought to be or what is the best, based on various
parameters, pros and cons.
 Markets
What is a market?: Collection of buyers and sellers that determine price of the commodities, by interacting with each other.

Types: Perfectly competitive markets (markets of agricultural goods – Mandis, Mobile cases sellers in same market lane), A

competitive market consists of large number of buyers and sellers so that no one has influence on prices and a single price

prevails.

Non-competitive markets : Markets where seller(s) can influence the price. E.g. Monopoly (Indian railways), Oligopoly

(Airline industry). Here, different prices charged by various producers. Thus, average price of goods is considered.

Market Definition/Extent of a market – Market definition involves identifying buyers and sellers, range of products to be

considered for a market (Stock market – can consider overseas consumers, Housing market – can be considered for a

particular area). Use – important for public policy decisions.

 Prices
Nominal v/s Real price

Nominal Price – Absolute price of a good unadjusted for Inflation. (Maggie Rs10 or the MRP
that’s mentioned on a product packaging)

Real – Price of a good relative to aggregate measure of prices. In short, it is the price adjusted
for inflation) (see Example 1.3, for details , Real price not so important for current exam)

What is Inflation ? : Rate of change of price levels in an economy. (Measured by Consumer

Price Index and Wholesale Price Index, in India)
 Demand & Supply
Why are tools of demand and supply important ?

1. Effects of changing market conditions (demand shock, supply shock, change in

consumers’ tastes) on market price and production.

2. Evaluating impact of Govt. policies (taxes, wage laws, subsidies) on producers and
consumers.: Examining how these policies affect consumer and producer decision,
giving an idea of change in demand and supply.
 Supply Curve
 Definition : Relationship between Quantity of good that
producers are willing to sell and price of the good
(Holding constant other factors!!)

A supply curve is always upward sloping. Why? Higher

the price, more firms are able and willing to produce and
sell. Or if the firm wishes to increase the
production/quantity supplied, they will increase the
price (to cover the cost).

Thus, when a firm wishes to change price of the good,

there is a movement along the supply curve.
 Supply Curve
Other variables that affect supply are prices of inputs/raw materials used for production. It could be cost of
labour (Wages), price of investment/loan (interest rate), rents paid for land or so on. There could be other
uncertain factors that may affect supply. For instance, flood or drought – that may affect farm production. Or
any disaster (like sudden in a factory fire that disrupts supply of goods).

If any of the above things happen – there is a shift in supply curve (Figure, next slide)

For instance, if inputs become expensive (rental price of land rises or price of machinery rises), What would the
producer do? He would now supply less at each price level to maintain his profits. Thus the supply curve shifts
towards left (S1 to S3). Due to uncertain conditions like drought, at each price, a farmer would decrease his
supply. Similarly, if inputs become cheaper or there is any technological advancement (that increases supply),
supply curve would shift towards right (S1 to S2).
Supply Curve
NOTE:
Along the supply curve, when price is
rising (that the seller raises to cover
his costs). Costs are rising due to rise
in quantity of good which demand
higher usage of inputs. Hence,
movement along Supply curve.
However, if costs rise due to change in
price of inputs, there is a shift in
supply curve and not a movement
along the curve.