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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
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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
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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
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2A: SUPPLY CURVE

FIGURE 3
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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
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FIGURE 3
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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
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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
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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
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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
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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
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1: PRODUCTION FUNCTION
The shapes of these curves reflect the law of variable proportions
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Costs of Production
A firm’s costs are determined by its production function
...
Figure 5
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FIGURE 5
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2B: LONG RUN COST

The average and marginal costs are U-shaped curves

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