INTRODUCTION TO Micro Econ.pdf

INTRODUCTION TO
MICROECONOMICS
Shine Raju Kappil

What is ECONOMICS
► Economics is the study of the use of scarce resources that have alternative uses. It is the study of how
individuals and societies choose to use the scarce resources that nature and previous generation provided.
► Oikonomia - Greek word – household management
► Important definitions
1) Wealth Definition- Adam Smith (Scottish Economist)
-Book- “An inquiry into the nature and causes of the wealth of nations”-1776
-It is the science of wealth which studies the process of production, consumption and
consumption and accumulation of wealth.
-N.W. Senior, J.S. Mill
2) Welfare Definition- Alfred Marshall (English Economist)
-Book- “Principles of Economics”-1890
-Economics is the study of mankind in the ordinary business of life. According to him it is on one
side, study of wealth and on other side study of man.
-Priority for human activities/human welfare than on wealth- wealth is not an end-it is means to end
of achieving human welfare

Continued
3) Scarcity definition- Lionel Robbins
-Book- ” An essay on the nature and significance of economic science”-1932
-Economics is the science which studies human behavior as a relationship between ends
and scarce means which have alternative uses.
-Human wants are unlimited, but resources are limited or scarce- necessity of allocation.
-This leads to economic problems.
4) Growth definition-Paul Samuelson-
-Book- “Economics: An Introductory Analysis”- 1948
-Economics is a social science concerned chiefly with the way society chooses to employ
its resources, which have alternative uses, to produce goods and services for present
and future consumption.
-introduces the dimension of growth under scarce situation-not just concerned with
allocation of resources but also expansion of resources to meet increasing human wants.
-can find commonality with definitions of Robbins and Samuelson.
5) Modern Definition-

Why we study Economics?
1) To understand global affairs
- especially economic dimensions
- eg: conflicts in Afghanistan, Syria- role of China
2) To understand the society
3) To invoke your thoughts
4) To develop a way of thinking- learning economic concepts helps to apply in real
life
-concepts of opportunity cost, marginalism etc.

Economics
Science Art
Normative Positive
Scope of Economics

1)Is it science or art?
1) Economics as a science
-Uses scientific methods in its research
-systematic study of knowledge or facts- systematically collected, classified & analyzed
Characteristics -Establish a correlation ship between cause & effect- (supply - price relationship)
of Science -Universal acceptance of scientific laws- (Law of demand, Law of DMU)
subjects -Scientific laws are tested and based on experiments- (Mixed economy -experiment)
-Ability to make future predictions
-Some economists claim that economics do have above characteristics and therefore economics is
a science
-But most often economic theories are based upon unrealistic assumptions that arise questions/doubts.
-Lack of accuracy
2) Economics as an art
-Knowledge is science, action is art- T.K Mehta
-Art is the practical application of knowledge for achieving goals
-Economics as an art tells us how to use these laws, rules and doctrines for the maximum
satisfaction of human well-being.
Inference: Economics is both science and art

2)Is it a positive science or normative science?
1) It is a Positive Science when
- It is concerned with criterion of “what is”
- It study things as they are.
- It ought to be neutral between the ends
- It never consider the moral rightness or moral sentiments
- No role for value judgements- stick on to facts and figures- not subjective.
- Supporters -NW Senior, Lionel Robbins
2) It is a normative Science when
- It is concerned with criterion of “what ought to be” or “what should be”
- It gives importance to moral sentiments.
- Economists can make value judgements- subjective in nature
- Supporters-AC Pigou, Alfred Marshall
Inference: Economics is both positive and normative science.

Scope of Economics
► Microeconomics and Macro economics
-Two branches of economics
Microeconomics deals with functioning of individual industries and analyze how individual
decision-making units (firms, households and industry) behave.
Macro economics deals with the economic behavior of aggregates- output, employment,
output, etc. on national scale.
-Macroeconomics take a top-down approach and consider economy as a whole. Macro
economic analysis are used to formulate economic and fiscal policies.

Central Problems of an
Economy
► All societies face the problem of how to make
the best use of limited, or scarce, resources.
► Though the needs and wants of people are
endless, the resources available to satisfy needs
and wants are limited.
► Resources are limited in two ways: 1) Physical
quantity (case of land- finite quantity), 2)
limited in Use (case of labour and equipment
used for single purpose at a time)
► All societies in general face three basic
questions.
► So economic problems arise due to unlimited
wants, limited resources and alternative uses of
resources.

Three Central Problems of an Economy
1 Problem of Allocation of resources
-What to produce, what quantity to produce
- How to produce
- For whom to produce
2 Problem of utilization of resources
- Fuller utilization of resources
- Efficient utilization of resources
3 Problem of growth of resources
- How to increase resources quantitatively
- How to increase the quality of resources

Three Basic
Questions
►Paul Samuelson provided a clear and
simple explanation of the economic
problem and discussed on how to make
solutions to these three basic questions –
What to produce? How to produce? And,
For whom to produce?
►To answer above questions, societies
organize their economies in three ways-
market economy, centrally planned
economy, mixed economy.

1) Problem of Allocation of Resources
► What to produce?
Resources are limited and our wants are unlimited .Therefore, we must choose what commodity
should produce at first. The economy must discover what things people really want. Having
decided on what produce we have also to decide the quantities in which the selected goods and
services have to produce.
► How to produce
This question relates to the choice of techniques of production. Technologically, there are various
ways of producing a given output. For example, cloth can be produced on hand looms or power
looms. If hand looms are used, relatively more labour and less capital is employed. This is known
as labour intensive method. In the case of power looms, more capital and less labour are required.
This is known as capital intensive .The choice of method will depend on the quantity of goods to
be produced and the availability of labour and capital. However, we selected one that the
maximum output can be produced with the given resources .
► For whom to produce
For whom to produce is the problem of distribution of goods and service .In brief, the question is
how the product is allocated among the four factors of production. The underlying issue here is
the functional distribution of output.
► These are called central problems because every economy has to face them and seek solutions to
them. Collectively, these central problems are called the Problem of Allocation of Resources

Types of Economies
To answer the three basic questions, societies organize their economies into three main ways. This
division is based on role of governmental interventions, freedom of supply and demand forces and
price determination within the societies.
► Market economy: An economy in which the market forces decide how economic resources will be
allocated.
Eg: USA, Canada, Japan etc.
► Centrally planned economy: An economy in which the government decides how economic
resources will be allocated. Also called command economy. Resources and business owned by
government.
Eg: USSR, North Korea, Cuba
► Mixed Economy: An economy in which most economic decisions result from the interaction of
buyers and sellers in markets but in which the government plays a significant role in the
allocation of resources.
Eg: India

Other Central Problems of
Economy
(2) The problem of optimum utilization of resources
Optimum utilization of resources has the following implications:
(i) All resources must be utilized and
(ii) Resources must be used efficiently
(3) The problem of growth of resources
Resources can increase if:
(i) There are quantitative changes in the resources
(ii) There are qualitative changes in resources

Production Possibility Frontier
► Production Possibility Curve- Transformation Curve- Production Possibility Boundary
► A graph that shows the combinations of outputs that the economy can possibly produce given the
available factors of production and the available production technology.
► It represents the central problems faced by societies and how they manage to allocate resources
and find solutions.
► For simplicity, we assume an economy that produce only two goods i.e. computers and cars. They
together use all the factors of production to produce these goods.
► If the economy uses all of its resources in the car industry, it produces 1000 cars and no computers
(x intercept). If it uses all resources in the computer industry, it produces 3000 computers and no
cars. These are the extreme possibilities.
► The economy can produce any combination of on or inside the the frontier. Full employment of
resources occur at points on the PPC (points A, B, E F). Inefficient utilization of resources occur
when resources are used inefficiently or under utilized. In PPC, inefficient combinations of
production lies on the interior of the PPC (See point D). Points outside the frontier are not feasible
given the economy’s resources. This is because resources are scarce (See point C.
► The shape of production possibility curve depends on the proportion of change in opportunity cost
of sacrificing good A to produce additional unit of good B. Opportunity cost is the value of the
next best alternative to any decision you make. If the economy has increasing opportunity costs,
the PPC will be bowed out from the origin or concave to origin. There are situations of decreasing
opportunity costs (convex to origin) and constant opportunity costs(straight line).

• Slope of PPC curve is the Marginal Rate of product transformation or Marginal rate of
transformation (MRT).
• PPC curve is downward sloping because to produce more of one we have to sacrifice a few units of
another. This is because resources were already being fully utilized.
• We use PPC model to explain problem of growth of resources which is represented by shift in the
PPC If the PPC curve shift outwards, there is growth and development in resources. This can be due
to advances in technology, changes in resources, changes in labour force, changes in productivit
etc. If PPC shift inwards there is reduction in available resources. This occurs when the economy
has suffered a loss or exhaustion of some of its scarce resources, failure to invest, erosion of
infrastructure, natural disaster, war, . This reduces productive potential of the economy.
• Asymmetric growth can also take place when an increase in productivity in one sector of the
economy
• PPC deals with central problems of economy, scarcity, efficiency, trade-offs, opportunity costs and
economic growth

Shifts in Production Possibility Frontier

Basic Competitive models
► Basic competitive models gives an answer of the basic problems of an economy i.e., who makes the
decision of what to produce, how to produce and for whom to produce.
► Economic theories have mostly been evolved and developed in the framework of a free market economy
in which the resources of the society are owned by individuals and firms.
► A market economy recognises and protects property rights, i.e., the rights that govern the ownership, use
and disposal of resources and the goods and services produced with their help.
► Assumptions of competitive models
-Rational self-interested consumers: Consumer makes a rational choice. Rational choice means that
consumers tries to maximise their satisfaction or act in a consistent manner given his budget constraint. So,
Rationality assumption about the behaviour of consumer implies that they will make choice to promote their
self interest.
-Profit-Maximising Firms: Just like consumers, economists assumes that firms will also pursue their self
interest in making choice. Generally rational behaviour (in terms of firms) means what goods will be
produced and in what quantities and also how those products will be produced as guided by the motive of
profit maximisation. They also face the constraint of the limited resources.
-Competitive market: In the basic competitive model neither the firm nor the consumers have any
market power to influence the prices of the goods and services they want to sell and buy. In fact it is
assumed that the perfect competition prevails in market. Under perfect competition there are large number
of buyers and sellers and their is no control over the price level. i.e., each firm and consumer is price taker.
-Product homogeneity, No power for buyer and seller

In market economy following factors plays an important and crucial role in the functioning of
market economy:
1) Property Rights
These are the social institutions that govern the ownership, use and disposal of resources,
goods and services. There are different types of property which individuals and firms can
privately own.
Real property : It includes land, buildings, capital equipment etc.
Financial Property : It includes shares and bonds, bank deposits etc.
Intellectual Property : It represents the products of creative effort and includes books
written, audio etc.
There are two attributes of property rights, namely, the right of the owner to use the
property as he likes and the right to sell it provide incentives to the owners to use their
property efficiency.
For Example, the owner of a factory building will try to make most profitable use of it by
producing a commodity which yields him maximum profits. This gives him incentives to think
carefully and try to obtain adequate information before making a decision about what to
produce and in what quantity. The owner also try to maintain it properly so that when in
future he wants to sell it he can do so at a good price.
Property rights should be enforced by the government for efficient use of all the resources, as
with the advancement of technology it is a big challenge these days.

2) Profits and prices : Incentives and Information
As we all know that everyone works and saves for wages and interest
respectively. Firms will not produce goods and services and bear risk of loosing
money if sufficient incentives are not given to them. Profits depends on the
prices of goods and services produced and cost incurred. As in perfect
competition firms are the price takers and have no control over price. They can
increase their profits by minimising the cost of production. Thus profits serve as
incentive for the firm to produce efficiently.
The working of price system ensures that those individuals and firms will get
goods who are willing and able to pay for them. Prices of goods and services
indicates how much money individuals are prepared to pay for them. In other
words prices convey information to the firms about how individuals value
different goods and services.

3) Rationing
It is the limiting of goods or services that are in high demand and short supply. It involves the
controlled distribution of a scarce good or service. Rationing artificially depresses the price by
putting constraints on demand. It is often found in socialistic or command economy where the
governments undertake mitigating the impact of scarcity and dealing with economic challenges.
In normal cases, when demand exceeds supply, prices rise, and high prices, in turn, curtail
demand and encourage new entrants to the market, increasing suppy and bringing prices back
to reasonable levels. Here rationing is not required as it create shortages
In certain situations like some goods and services (eg: food, fuel, and medical care whose
demand is inelastic (inelastic means quantity demanded doesn’t fall in accordance to increases
in price). Here entry of new suppliers to balance markets will be impossible if the shortage
occurs due to war, natural hazrads, crop failure. Here government enter into the market and
practice rationing to avoid bigger economic crisis.

Reading and working with Graphs
►Many concepts that we study can be expressed with numbers- price of a good, the quantity of a good
etc. These economic variables are often related to one another. One way of representing the
relationships among the variables is with graphs.
►Benefits of Graphs: It expresses ideas visually and clearly than described with equations or words.
Secondly, while explaining economic data, graphs provide powerful way of finding and interpreting
patterns.
►Numerical information can be expressed graphically in many ways. But an efficient economist chooses
the type of graph that best suits the purpose at hand.
►Economists use graphs in general to study the mathematical relationships among variables.

X axis – The horizontal line at the base of the graph
Y- Axis- The vertical line on the left hand side of the
graph
In economics, we often use graph with price (p)
represented on the y axis and quantity (q) represented
on the x axis
An intercept is where a line on a graph
crosses(intercepts) the x axis or y axis. Mathematically,
the x-intercept is the value of x when y=0. similarly,
the y- intercept is the value of y when x=0.
The point where two lines on a graph cross is called an
intersection point.
The slope tells us how steep a line on a graph is as we
move from one point on the line to another point on
the line. Slope is the change in the vertical axis divided
by the change in the horizontal axis. The formula is
often referred as” rise over the run”, I,e. change in
distance on y axis(rise) divided by the change in the x
axis(run).

Graph of Two variables
To study and display two variables on a single graph, economists use coordinate system.
For eg, we want to study the relationship between study time and grade point average in a class. For
each student in the class , we record a pair of numbers. These the numbers are placed in paraentheses as
an ordered pair and appear as a single point on the graph. The first number in ordered pair is called as x
coordinate which tells the horizontal location of the point. The second number called the y coordinate
tells us the vertical position of the point. The point with both an x-coordinate and y coordinate of zero is
known as the origin. Below graph is an example of scatterplot (it plots the scattered points)

Curves in the Coordinate system
A curve is a line on a graph that depicts a relationship between two variables
It may be either a straight line or a curved line
If the curve is a straight line, the variables have a linear relationship. If the curve is not a straight line,
the variables have a nonlinear relationship.
Cause and Effect
A causal relationship exists between two variables when the value taken by one variable directly
influences or determines the value taken by the other variable.
In a causal relationship, the determining variable is called the independent variable, the variable it
determines is called the dependent variable.
Two variables have a positive relationship when an increase in the value of one variable is associated
with an increase in the value of other variable. It is illustrated by a curve that slopes upward from left
to right.
Two variables have a negative relationship when an increase in the value of one variable is associated
with a decrease in the value of the other variable. It is illustrated by a curve that slopes downward
from left to right.

INTRODUCTION TO Micro Econ.pdf

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