Economy
Microeconomics and Basic Terminology
1.1 An Introduction to the Field of Economics
● Origin of Economics: "Economics" is derived from the Ancient Greek word
oikonomikos, meaning household management.
● Definition and Scope: Economics is a vast and multifaceted discipline that
examines how individuals, businesses, governments, and societies allocate
limited resources to fulfil their needs and desires.
● Branches of Economics: The field is broadly categorized into
Microeconomics, which focuses on individual units, and Macroeconomics,
which addresses overall economic aggregates.
1.2 Evolution of Economic Thought
1.2.1 Early Economic Thought
● Ancient Greece: Philosophers like Plato and Aristotle explored ideas of
economic justice, wealth distribution, and the division of labor.
● Mercantilism: Emphasized government intervention to increase national
wealth through trade surpluses and gold accumulation.
1.2.2 Classical Economics
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● Adam Smith: In The Wealth of Nations, he advocated for free markets and
the concept of the invisible hand to achieve economic efficiency.
● David Ricardo: Developed key theories on comparative advantage, rent, and
wages.
● Thomas Malthus: Warned of population growth outpacing food production,
potentially leading to famine and societal challenges.
1.2.3 Neoclassical Economics
● Marginalism: Focused on the role of marginal benefits and costs in
decision-making and market equilibrium.
● Alfred Marshall: Advanced theories on supply and demand, consumer
behavior, and firm production.
● Leon Walras: Introduced the general equilibrium model to study
interconnected markets.
1.2.4 Keynesian Economics
John Maynard Keynes: Critiqued the idea of self-correcting markets,
proposing government intervention via fiscal policy to maintain economic
stability.
1.2.5 Modern Approaches
● Monetarism: Highlights the role of money supply and central bank policies in
influencing economic activity.
● New Keynesian Economics: Merges Keynesian principles with
microeconomic foundations to understand economic fluctuations and policy
impacts.
● Behavioral Economics: Incorporates psychology and cognitive biases into
economic models to explain deviations from rational decision-making.
1.2.6 Additional Approaches
● Marxist Economics: Examines capitalism through the perspective of class
struggle, emphasizing exploitation, power dynamics, and the conflicts
between labor and capital.
● Institutional Economics: Highlights the influence of institutions—such as
laws, norms, and cultural practices—on economic behavior and outcomes.
● Feminist Economics: Focuses on gender disparities in economic systems,
advocating for inclusive policies that promote justice and equality across
genders.
1.3 Microeconomics and Macroeconomics
Aspect
Description
Microeconomics
Examines the economic behavior of individual units, including
consumers, households, and firms, focusing on
decision-making and resource allocation.
Macroeconomics Studies overarching economic factors like national income,
employment, inflation, and economic growth.
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Interdependence
It highlights the mutual dependence of microeconomics and
macroeconomics, offering essential insights for a holistic
understanding of economics.
1.4 UNDERSTANDING MICROECONOMICS
Scarcity, Choice, and Opportunity Cost in Microeconomic Thinking
Microeconomics is centered on decision-making under scarcity, which forces
individuals and firms to make trade-offs. This results in opportunity costs—the
value of the next best alternative forgone. For instance, buying a car might mean
giving up a holiday; in this case, the holiday is the opportunity cost. Firms, too, face
similar trade-offs, like choosing one product over another for production.
The law of diminishing returns explains that as more variable inputs (e.g., labor)
are added to fixed resources (e.g., land), the additional output per unit of input
gradually diminishes. Over time, this leads to a decline in overall production
efficiency.
The Price Mechanism in Microeconomics
Markets function through the interaction of producers and consumers, where supply
and demand determine prices via the price mechanism—often referred to as the
"invisible hand." This mechanism ensures resources are allocated efficiently,
balancing production and consumption.
In earlier economies, trade was conducted through barter, but the introduction of
money transformed transactions by providing a medium of exchange and a unit of
account. This allowed traders to adjust prices more efficiently: setting prices too low
caused stockouts, while prices set too high led to unsold inventory.
The development of microeconomics owes much to Alfred Marshall’s Principles of
Economics (1890), which formalized key concepts such as supply, demand,
elasticity, and marginal utility. These concepts remain central to understanding
how markets determine prices.
1.4.1 Demand Side of the Economy
Aspect
Description
Law of Demand
States that, all else being equal, as the price of a good or
service increases, demand decreases, and vice versa.
Example: A drop in smartphone prices increases their
demand, while a price hike reduces it.
Determinants of
Demand
Factors influencing demand include price, consumer income,
tastes/preferences, prices of related goods, and future
expectations.
Elasticity of
Demand
Measures the responsiveness of quantity demanded to
changes in price.
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Demand Curve
Typically slopes downward, showing an inverse relationship
between price and quantity demanded. For example, a price
drop from OP₀ to OP₁ increases demand from OQ₀ to OQ₁.
Exceptional
Demand Curve
In rare cases, the demand curve slopes upward, where a
price increase leads to higher demand and a price decrease
leads to lower demand.
Types of Goods
1. Inferior Goods
○ Definition: Demand decreases as consumer income increases.
○ Reason: Consumers prefer higher-quality substitutes when incomes
rise.
○ Example: Generic brands or low-cost staple foods.
2. Giffen Goods
○ Definition: Goods with an upward-sloping demand curve (demand
rises as price rises).
○ Reason: Essential items with no close substitutes at the same price.
○ Example: Bread, rice, and wheat in specific economic conditions.
3. Veblen Goods (Luxury Goods)
○ Definition: Demand increases with price due to their status and
exclusivity.
○ Reason: People buy them to show wealth and status.
○ Example: Rolex watches, Rolls Royce cars.
4. Speculative Goods
○ Definition: Demand rises because people expect future price
increases.
○ Reason: Consumers want to benefit from anticipated price surges.
○ Example: Stock market investments, real estate.
5. Substitute Goods
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○ Definition: Goods that can replace each other.
○ Reason: If one becomes expensive, people switch to the other.
○ Example: Tea and coffee.
6. Complementary Goods
○ Definition: Goods consumed together.
○ Reason: A price increase in one reduces the demand for the other.
○ Example: Bread and jam, tea and sugar.
7. Normal Goods
○ Definition: Demand increases as income increases.
○ Reason: People buy more as they can afford better products.
○ Example: Branded clothing, electronics.
8. Public Goods
○ Definition: Available to all, cannot be restricted, and one person's use
doesn’t reduce availability for others.
○ Example: Street lighting, national defense.
9. Private Goods
○ Definition: Goods meant for individual consumption, excludable and
rivalrous.
○ Example: Food, clothing.
10. Club Goods
○ Definition: Goods that are excludable but not rivalrous.
○ Example: Gym memberships, private parks.
11. Common Goods
○ Definition: Goods that are non-excludable but rivalrous (prone to
overuse).
○ Example: Fisheries, forests.
1.4.2 Supply Side of the Economy
Aspect
Description
Law of Supply
States that, all else being equal, as the price of a good or
service rises, the quantity supplied also rises, and vice versa.
Example: Higher coffee prices encourage farmers to grow
more, while lower prices reduce production.
Determinants
of Supply
Factors influencing supply include the commodity's price,
production costs, taxes, and profit objectives.
Elasticity of
Supply
Measures the responsiveness of the quantity supplied to
changes in price.
1.4.3 Supply Curve
There is a direct relationship between price and quantity supplied. An increase in
price from OP1 to OP2 results in an increase in quantity supplied from OQ1 to OQ2.
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1.5 MARKET EQUILIBRIUM AND COMPETITION
Market Equilibrium
Market equilibrium is achieved when the quantity demanded equals the quantity
supplied, determining the market price. For instance, at a bakery, equilibrium occurs
when the daily production of bread is sold out by closing time, with no leftovers or
shortages.
The price is determined at the point where the supply and demand curves intersect.
● Setting the price above equilibrium results in a surplus, where the quantity
supplied exceeds the quantity demanded. To reduce the surplus, the price
must be lowered.
● Conversely, setting the price below equilibrium creates excess demand. The
solution is to raise the price to balance supply and demand.
1.6 Theory of The Firm in Microeconomics
The theory of the firm, a microeconomic branch, explores diverse organizational
structures within industries and draws insights from these structures.
1.6.1 Market Structures
Structure
Description
Perfect
Competition
In this market, many firms produce identical goods, and there
are no barriers to entry or exit. Both producers and consumers
have perfect market knowledge. Prices and output tend toward
equilibrium. The demand curve is perfectly elastic, showing
horizontal demand. While rare in real life, certain financial
markets and online sectors exhibit characteristics of perfect
competition.
Monopoly
A monopoly occurs when a single firm dominates the market,
often due to statutory rights or government ownership. The firm
can set prices, leading to super-normal profits. Government
regulations are common to control monopolistic power.
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Oligopoly
In an oligopoly, a few influential firms dominate the market.
These firms have substantial knowledge about each other and
can predict competitor actions. Oligopolistic markets often
feature product differentiation, entry barriers, and significant
price influence by a few large firms.
Monopolistic
Competition
This market structure has many firms that differentiate their
products. Despite offering similar products, perceived
differences allow for short-term monopolistic behavior.
Consumer awareness of these differences is crucial, and entry
and exit barriers are lower than in oligopolistic markets.
1.7 Market Intervention in Capitalist Systems
In capitalist systems, markets are generally allowed to operate freely, but public
goods and services require government intervention for adequate provision. This
often involves adjusting prices above or below equilibrium.
● Maximum Price Intervention: Protecting Consumers
A maximum price is set to protect consumers, typically below the equilibrium
price. This leads to excess demand, where the quantity demanded exceeds
supply. Historical examples, such as the UK's intervention during World War
II, show the potential for illegal markets and other consequences when
maximum prices are imposed.
● Minimum Price Intervention: Protecting Producers
A minimum price is set to protect producers, typically above the equilibrium
price. This results in a situation where the quantity supplied exceeds the
quantity demanded. For example, the European Union’s common agricultural
policy, which enforces a minimum price system, has occasionally led to
surpluses in the agricultural sector.
Managing Consequences:
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Insights from Microeconomic Analysis: While the impact of intervention in
the price system may not always be universally undesirable, microeconomic
analysis emphasizes the need to understand and manage the consequences
effectively. Society must navigate the implications of such interventions to
ensure a balanced and efficient economic system.
Maximum price is OP1. At this point, the quantity demanded (OQ1) exceeds
quantity supplied (OQ2). The ‘black market’ price is OP2.
1.8 Elasticity of Demand and Supply
Elasticity in economics shows how much the quantity of a product changes when its
price changes.
● If a small price change causes a big change in quantity demanded, it is
called highly elastic demand.
● If a price change causes little or no change in demand, it is called highly
inelastic demand.
Why is it important?
● Businesses use elasticity to decide pricing strategies.
● Governments use it to predict the effects of taxes and policies.
How to Calculate Elasticity
1. Price Elasticity of Demand
2. Price Elasticity of Supply
Other Types of Elasticity
1. Income Elasticity
○ Measures how demand or supply changes when people’s income
changes.
○ Example: Demand for luxury goods increases as income rises.
2. Cross Elasticity
○ Measures how the demand for one product changes when the price of
a related product changes.
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○ Example: If coffee becomes expensive, demand for tea (a substitute)
may increase.
1.8.1 Elasticity of Demand
Types of Price Elasticity of Demand
1. Perfectly Elastic Demand
○ Definition: Quantity demanded changes infinitely for even a very small
change in price.
○ Graph: A horizontal demand curve.
○ Example: Perfect substitutes in highly competitive markets.
○
2. Perfectly Inelastic Demand
○ Definition: Quantity demanded remains unchanged regardless of price
changes.
○ Graph: A vertical demand curve.
○ Example: Essential life-saving medicines.
○
3. Relatively Elastic Demand
○ Definition: A small change in price causes a large change in quantity
demanded.
○ Graph: A flatter demand curve.
○ Example: Luxury goods like branded clothing.
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○
4. Unitary Elastic Demand
○ Definition: The percentage change in quantity demanded is equal to
the percentage change in price.
○ Graph: A hyperbolic demand curve.
○ Example: Goods where total expenditure remains constant.
○
5. Relatively Inelastic Demand
Definition: A large change in price causes only a small change in
quantity demanded.
○ Graph: A steeper demand curve.
○ Example: Necessities like salt or electricity.
○
○
1.8.2 Elasticity of Supply
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Relatively Elastic Supply
○ Definition: A more than proportional change in quantity supplied
due to a price change.
○ Graph: A flatter supply curve.
○ Example: Consumer electronics, where production can quickly
increase with higher prices.
2. Unitary Elastic Supply
○ Definition: A proportional change in quantity supplied matches the
change in price.
○ Graph: A straight line passing through the origin.
○ Example: Goods with balanced production scalability, like standard
furniture.
3. Relatively Inelastic Supply
○ Definition: A less than proportional change in quantity supplied due
to a price change.
○ Graph: A steeper supply curve.
○ Example: Agricultural products where production cannot be quickly
increased.
4. Perfectly Elastic Supply
○ Definition: Infinite change in quantity supplied for even a very small
price change.
○ Graph: A horizontal supply curve.
○ Example: Goods in perfectly competitive markets where producers can
supply any amount at a fixed price.
5. Perfectly Inelastic Supply
○ Definition: No change in quantity supplied regardless of price
changes.
○ Graph: A vertical supply curve.
○ Example: Fixed resources like land or unique artworks.
●
During the COVID-19 pandemic, the price of masks went up because a lot of people
needed them, and companies made more masks to meet the demand illustrating
elastic supply. However, we couldn’t suddenly have more doctors, so the number of
doctors didn’t increase much. This is an example of a relatively inelastic supply.
1.9 Some Basic Terms and Concepts
a. Marginal Utility: The additional satisfaction gained from consuming an
additional unit of a good or service.
b. Opportunity Cost: The cost of foregone alternatives when one option is
chosen over another.
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c. Market Equilibrium: A situation in which market supply and demand balance
each other, resulting in stable prices.
d. Externalities: Costs or benefits that affect a party who did not choose to incur
that cost or benefit.
e. Substitution Effect: The change in consumption resulting from a change in
the price of a good, making consumers substitute away from higher-priced
goods to lower-priced ones.
f.
Income Effect: The change in consumption resulting from a change in real
income.
g. Marginal Cost: The cost of producing one additional unit of a good.
h. Diminishing Marginal Returns: A principle stating that as investment in a
particular area increases, the rate of profit from that investment, after a certain
point, cannot continue to increase if other variables remain constant.
i.
Price: The amount of money required to purchase a good or service.
j.
Cost: The expenses incurred in producing or acquiring a good.
k. Income: Monetary or other returns, earned or unearned, accruing over a
period.
l.
Goods and Services: Tangible products (goods) and activities performed by
service providers (services).
m. Final Good: A product that has completed its production and transformation
process.
n. Consumption Good: Goods and services consumed upon purchase.
o. Capital Good: Assets used in production that do not transform the process.
p. Fixed Asset: Business assets used for more than one accounting year.
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q. Depreciation: Decline in value of fixed assets over time due to use or
obsolescence
1.10 CONCLUSION
Microeconomics is not just a theoretical framework; it is a practical tool-kit that offers
invaluable perspectives for various stakeholders - from policymakers and business
leaders to individual consumers. Its principles permeate every aspect of economic
life, enabling a deeper understanding of the economic forces that shape our daily
experiences and the broader global economy.
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