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BUSINESS
ECONOMICS

MICROECONOMIC ANALYSIS
1: INTRODUCTION

TABLE OF CONTENTS
1
...
Introduction
3
...
Consumer Behaviour
Consumer Preferences
Budget Constraint
Consumer Choice
5
...
Pricing and Output Decisions under different market structures
Perfect Competition
Monopoly
Monopolistic Competition
Oligopoly
Bilateral Monopoly
7
...
Welfare Economics and Market failure
Welfare Economics: Basic Ideas
Market Failure
Externalities
Public Goods
Asymmetric Information
9
...
Introduction
Microeconomics is the branch of economics based on the economic behaviour of small economic
units: consumers, firms, workers, savers, individual industries, markets and so on
...
Consumers decide how much of various goods to purchase, workers
decide what jobs to take, and firms decide how many workers to hire and how much output to
produce
...


3
...
Markets
refer to the interplay of all potential buyers and sellers involved in production, sale, or purchase
of a particular good or service
...
Innumerable factors could have an impact, but some are
clearly more important than others
...
Prices are the result of market
transactions, but they also strongly influence the behaviour of buyers and sellers in every market
...


The Demand Curve
The amount of a good that any consumer wishes to purchase depends on many factors: price of
the good, income, age, price of related goods, tastes, etc
...

According to the law of demand, ceteris paribus, the lower the price of a good, the larger
the quantity consumers wish to purchase
...
1A)
...
For example, an increase
in income may lead to a rightward shift in demand curve as depicted in Figure 3
...


FIGURE 3
...
1B: SHIFT IN DEMAND

The Supply Curve
The amount firms offer for sale depends on many factors—price of the good, state of technology,
cost and productivity of the inputs required for production, and so on
...
It generally slopes
upwards (Figure 3
...

A shift in the supply curve arises when the underlying factors influencing the supply, like
technology, prices of inputs, change
...
2B, a technological change causes the
supply curve to shift to the right
...
2A: SUPPLY CURVE

FIGURE 3
...
3 Market Equilibrium
The demand curve shows what consumers wish to purchase at various prices, and the supply
curve shows what producers wish to sell
...
The
intersection identifies the equilibrium price and quantity in the market
...
As illustrated in Figure 3
...


FIGURE 3
...
4 Elasticity of Demand
Elasticity measures the sensitivity of one variable to another
...
It is denoted by, ep:
ep = (%∆Q)/ (%∆P)
The percentage change in a variable is the absolute change in the variable divided by the original
level of the variable
...
When the price of a good increases
ep =of(∆Q/Q)/
the quantity demanded usually falls
...

When the price elasticity is greater than one, demand is price elastic, because the
percentage decline in quantity demanded is greater than the percentage increase in price
...
In general, the
price elasticity of demand for a good depends on the availability of other goods that can be
substituted for it
...
Demand will then be highly price elastic
...


4
...
We
study how consumers make consumption decisions, and how their preferences and budget
constraints determine their demand for various goods
...
The theory of consumer behaviour undertakes three basic assumptions about people’s
preferences for one market basket versus another
...
Thus, for any two market baskets A and B, a consumer will
prefer A to B, will prefer B to A, or will be indifferent between the two
...
Transitivity means that if a consumer prefers
basket A to basket B and basket B to basket C, then the consumer also prefers A to C
...
Consumers always prefer
more of any good to less
...

These three assumptions form the basis of consumer theory
...

Consumer preferences can be graphically illustrated through indifference curves
...
1)
...
A utility function (measure that
assigns a level of utility to individual market baskets) can be represented by a set of indifference
curves
...
1 shows three indifference curves (with different utility levels – U3 > U2> U1)
associated with a particular utility function
...
1: INDIFFERENCE CURVES

Budget Constraint
So far, we have focused on the first element of consumer theory – consumer preferences
...
The budget line indicates all combinations of goods for which the total amount of
money spent is equal to income
...
Given the consumer’s income as M and prices of the two
goods as Px and Py respectively, the budget line represents the following budget constraint:
Px x + Py y = M
The budget line (Figure 4
...
The magnitude of the slope tells us the rate at which the two
goods can be substituted for each other without changing the total amount of money spent
...
2: BUDGET LINE

Consumer Choice
Given preferences and budget constraints, consumer’s choice of different goods can be
determined
...

The maximizing market basket must satisfy two conditions:
 It must be located on the budget line
...

As illustrated in Figure 4
...
This point
is the consumer’s equilibrium point
...
At E, equilibrium point, the
marginal rate of substitution (MRS) between the two goods equals the price ratio
...

Thus at the consumer’s equilibrium,
MRS = Px / Py

FIGURE 4
...
Objective of the Firm
The theory of the firm focuses on the supply side of the market
...


The Production Function
The production function summarizes the characteristics of existing technology
...
It is denoted as:
Q = f (K,L)
Where Q is the output, K is the units of capital, and L is the units of labour used in production of
Q
...
1
...
As labour increases, ceteris paribus, output increases
...
The marginal product of labour is defined as the

change in output resulting from a change in labour, keeping all other factors constant
...
Thus
MPL = ∂Q/∂L; APL = Q/L
As depicted in Figure 5
...
Also, when marginal product is
greater than average product, average product is increasing; and when marginal product is less
than average product, average product is decreasing
...
The relationship between the total product curve and marginal product is also
important
...
When marginal product is zero, total product reaches its maximum
...
1: PRODUCTION FUNCTION
The shapes of these curves reflect the law of variable proportions
...


Costs of Production
A firm’s costs are determined by its production function
...
Figure 5
...


FIGURE 5
...
2B: LONG RUN COST

The average and marginal costs are U-shaped curves
...
When average cost is at a minimum, marginal cost is equal
to average cost
...
2B)
...
It is also a U-shaped curve,
depicting economies and diseconomies of scale
...

Many firms produce more than one product, which may be closely linked to one another
...
Two situations can arise—
economies of scope and diseconomies of scope
...
In contrast, if a firm’s joint output is less than that which could
be achieved by separate firms, then its production process involves diseconomies of scope
...
Pricing and Output Decisions under Different Market Structures
Perfect Competition
In perfect competition, there are a very large number of firms in the industry and the product is
homogeneous
...
Thus although competition is perfect, there is
no rivalry among the individual firms
...
The products of the firms are perfect substitutes for one another so that the priceelasticity of the demand curve of the individual firm is infinite
...


Monopoly
In a monopoly situation there is only one firm in the industry and there are no close substitutes
for the product of the monopolist
...
Entry is blockaded
...
Hence the demand of the individual firm has a negative slope, but its
price elasticity is high due to the existence of the close substitutes produced by the other firms in
the industry
...
Thus each seller thinks that he would keep some
of his customers if he raised his price, and he could increase his sales, but not much, if he lowered
his price: his demand curve has a high price elasticity, but is not perfectly elastic because of the
attachment of customers to the slightly differentiated product he offers
...


Oligopoly
Oligopoly is an industry structure characterized by a few large firms producing most, or all, of
the output of some product
...
The characteristic of oligopoly that distinguishes it from other forms of market structures is
the mutual interdependence of firms in the industry
...
Therefore, any price or output decision a firm makes must
be made with the thought of its rivals in mind and with some sort of guess about how rivals will
respond
...

The nature of an oligopolistic industry makes it impossible for economists to develop a
single model that is applicable to all industries exhibiting oligopolistic characteristics
...

The implications of these models vary since the assumptions made about rival behaviour differ,
and when the assumptions vary, more outcomes become possible
...

Non-collusive oligopoly is a market where firms work independently and strategically by
recognizing the mutual interdependence; whereas collusive oligopoly is one where firms
maximize their joint profits by entering into a collusive agreement to restrict competition and to
avoid uncertainties arising from oligopolistic interdependence
...
For example, if a single firm produced all the copper in a country and if only one
firm used this metal, the copper market would be a bilateral monopoly market
...
Economic
analysis can only define the range within which the price will eventually be settled
...
Under conditions of
bilateral monopoly economic analysis leads to indeterminacy which is finally resolved by
exogenous factors
...
Pricing Strategies
Price theory pertains to the determination of prices of goods and services by firms
...
A range of pricing strategies can be employed by a business firm when selling a
good or service
...


Marginal Cost Pricing
Marginal-cost pricing is a pricing technique in which the price of a product is set equal to its
marginal cost, i
...
, the extra cost of producing an extra unit of output
...


Mark-up Pricing
Mark up pricing is a strategy firms use to maximize profits
...


Price Discrimination
Price discrimination is a pricing technique where firms charge different prices to different groups
of buyers for identical or similar goods or services
...


Factor Pricing
Factor pricing theory is concerned with the evaluation of the services of the factors of production
...
e
...


Peak-load Pricing
It is a method of pricing in which at the time of peak demand prices rise to balance demand and
supply
...
Pricing
higher when demand is at its peak will balance out the supply and demand so that there is no
shortage on either end
...
Welfare Economics and Market Failure
Welfare Economics: Basic Ideas
Microeconomic theory also deals with normative issues, which is studied as a separate branch,
that is, welfare economics
...

There are two fundamental theorems of welfare economics
...
According to the
Second theorem of Welfare Economics, as long as preferences are convex, then every Pareto
efficient allocation can be supported as a competitive equilibrium
...
As long as the social welfare function is increasing in
each individual’s utility, a welfare maximum will be Pareto efficient
...


Market Failure
In some situations, even competitive markets are not capable of producing efficient outcomes
...
Such a situation is described as market failure
...
This is because there is a divergence between private benefits and social
benefits (benefits of the society as a whole) that arises from carrying out a particular activity
...


EXTERNALITIES
Externalities are the harmful or beneficial effects of activities that are borne by people who are
not directly involved in the market exchanges
...
However, government intervention and the
legal system can ensure that property rights are well defined, so that efficiency enhancing trades
can be made
...
Cures for production externalities include the
use of Pigouvian taxes, setting up a market for the externality, or allowing firms to merge
...
They are goods for
which everyone must consume the same amount, such as national defense, air pollution, and so
on
...
In general, purely individualistic mechanisms
will not generate the optimal amount of a public good because of this free rider problem
...
Such
methods include the command mechanism, voting, and Vickrey-Clarke-Groves auction
mechanism
...
Asymmetric information is a
situation where one side in a transaction has more information than the other side
...
In situations of hidden actions, it is likely that the more informed side will indulge in wrong
actions, leading to the problem of moral hazard
...
To cope up with the problem of moral hazard, insurance companies carry
out different practices in the form of co-insurance and deductable
...

The asymmetry in information can also arise from hidden characteristics, wherein one party
knows some characteristics which the other party would like to know, but does not know
...
This leads to the problem of adverse selection
...
A buyer of a car gets to trade with sellers of bad cars only; a health
insurance company gets to trade with only unwell people
...


9
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
 It involves the study of how individual markets function
...

 Microeconomic theory examines how these decisions and behaviour affect the supply and
demand for goods and services, which determines prices, and how prices, in turn,
determine the quantity supplied and quantity demanded of goods and services
...

It examines how consumers make consumption decisions, and how their preferences and
budget constraints determine their demand for various goods
...
It studies the behaviour
of producers, how firms can produce efficiently and how their costs of production
change with changes in both input prices and the level of output
...
These include marginal cost pricing, mark-up pricing, price discrimination,
factor pricing, and peak-load pricing
...
It deals with the way various economic arrangements
affect the welfare or well-being, of all members of society
...
Such a situation is described as market failure
...




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