Micro economics

Micro Economics PGDM TRIMESTER- I

Dr. Poonam Kain

Apeejay Institute of Technology

Greater Noida

Why to study economics To introduce key economic concepts like scarcity,

rationality, equilibrium, time perspective and opportunity cost.

To explain the basic difference between microeconomics and macroeconomics.

To help the reader analyze how decisions are made about what, how and for whom to produce.

To define managerial economics and demonstrate its importance in managerial decision making.

Economics How a society tries to solve the human problems of

unlimited wants and scarce resources.

Deals with the society as a whole and human behaviour in particular

Studies the production, distribution, and consumption of goods and services.

A science in its methodology, and art in its application.

Economics Scientific study of the choices made by

individuals and societies with regard to the alternative uses of scarce resources employed to satisfy wants.

Application of economic theory and the tools of analysis of decision

science to examine how an organisation can achieve its objectives most

effectively

Study of allocation of the limited resources available to a firm or other

unit of management among the various possible activities of that unit

Applies economic theory and methods to business and administrative

decision-making

Application of economic principles and methodologies to the decision-

making process within the firm or organization

Fundamental Concepts of economics Ceteris Paribus

Latin phrase

“With other things (being) the same” or “all other things being

equal”.

Rationality Consumers maximize utility subject to given money income.

Producers maximize profit subject to given resources or minimize

cost subject to target return.

Fundamental Concepts of economics Positive and Normative

Positive economics: “what is” in economic matters

Establishes a cause and effect relationship between variables.

Analyzes problems on the basis of facts.

Normative economics: “what ought to be” in economic matters.

Concerned with questions involving value judgments.

Incorporates value judgments about what the economy should be like.

Fundamental Concepts of economics

Short Run and Long Run

Short run: Time period not enough for consumers and producers to

adjust completely to any new situation.

Some inputs are fixed and others are variable

Long run: Time period long enough for consumers and producers to

adjust to any new situation. All inputs are variable

Decisions to adjust capacity, to introduce a larger plant or continue with

the existing one, to change product lines.

Fundamental Concepts of economics Concept of scarcity

Unlimited human wants Limited resources available to satisfy such wants Best possible use of resources to get:

maximum satisfaction (from the point of view of consumers) or maximum output (from the point of view of producers or firms)

Concept of opportunity cost Opportunity cost is the benefit forgone from the alternative that is not

selected. Highlights the capacity of one resource to satisfy multitude of wants Helps in making rational choices in all aspects of business, since

resources are scarce and wants are unlimited

Fundamental Concepts of economics Concept of margin or increment

Marginality: a unit increase in cost or revenue or utility. Marginal cost: change in Total Cost due to a unit change in output.

Marginal revenue: change in Total Revenue due to a unit change in

sales.

Marginal utility: change in Total Utility due to a unit change in

consumption.

Incremental: applied when the changes are in bulk, say 10% increase

in sales.

Summary

Economics studies the choices made by individuals and societies in regard to the alternative uses of scarce resources which are employed to satisfy unlimited wants.

Microeconomics is the study of the behaviour of individual economic units, such as an individual consumer, a seller, a producer, a firm, or a product.

Macroeconomics deals with the study of aggregates, the economy as a whole.

Summary• Production Possibilities Curve (PPC) is a graph that shows

the different combinations of the quantities of two goods that can be produced (or consumed) in an economy, subject to the limited availability of resources.

• The knowledge of managerial economics helps to understand the interrelationships among the various functional units of any firm (namely production, marketing, HR, finance, IT and legal)

• Decision sciences provide the tools and techniques of analysis used in managerial economics, in particular numerical and algebraic analysis, optimization, statistical estimation and forecasting.

Consumer Choice Given the prices of different commodities, consumers decide

on the quantities of these commodities according to their paying capacity, and tastes and preferences.

Consumers’ choices, tastes and preferences rests on the following assumptions: Completeness: A consumer would be able to state own

preference or indifference between two distinct baskets of goods.

Transitivity: An individual consumer’s preferences are always consistent.

Non-satiation: A consumer is never satiated permanently. More is always wanted; if “some” is good, “more” of the good is better.

Consumer Choice

Commodities are desired because of their utility

Utility is the attribute of a commodity to satisfy or satiate a consumer’s

wants

Utility is the satisfaction a consumer derives from consumption of a

commodity

Mathematically: utility is the function of the quantities of different

commodities consumed:

U= f(m1, n1, r1)

Utility is the measure of satisfaction a consumer derives from consumption of a commodity; it is an attribute of a commodity to satisfy a consumer’s needs. According to cardinal school, utility is measurable like any other physical commodity.

Cardinal Utility Analysis

Marshall and Jevons opined that Utility is a cardinal concept and is measurable (in utils) like any other physical commodity

Total Utility (TU) Sum total of utility levels out of each unit of a commodity

consumed within a given period of time Marginal Utility (MU)

Change in total utility due to a unit change in the commodity consumed within a given period of time.

MU=TUn -TUn-1 or MU=


Law of Equimarginal Utility

Marginal utilities of all commodities should be equal

The consumer has to distribute his/her income on different

commodities so that utility derived from last unit of each

commodity is equal for all other commodities in the

consumption basket.

Mathematically:

IN

N

M

M MUP

MU

P

MU ...

As per law of equimarginal utility, a consumer will maximize utility when the marginal utility of the last unit of money spent on each commodity is equal to the marginal utility of the last unit of money spent on any other commodity.


Law of Diminishing Marginal Utility

Marginal utility for successive units consumed goes on decreasing.

When the good is consumed in standard quantity, continuously and in multiple units and the good is not addictive in nature.

The following diagrams show Total Utility (TU) and Marginal Utility (MU) curves

Quantity of X

TU of X

O

TU

Quantity of X

MU of X

O

MU

As per law of diminishing marginal utility, as you one consumes more and more units of a commodity, total utility would goes on increasing, but at a diminishing rate.

Marginal Utility and Demand Curve MU curve is downward sloping.

For any given amount of income when price of the commodity is PC, the consumer would consume QC quantity of the commodity (point C on the MU curve, where MU= PC)

When price increases to PB, the consumer has to readjust consumption to restoring level of utility.

the new equilibrium is at point B on the MU curve where MU= PB

As price goes on increasing, the desired consumption of the commodity for the consumer goes on diminishing and vice versa. Points A, B, C, and so on, would thus lie on the demand curve of the consumer for the commodity.

C PC

MU, P

Quantity

MU=D

QC

B PB

QB

PA A

QA O

Edgeworth, Fisher and others negate the physical measurement of utility.

A consumer is able to rank different combinations of the commodities in

order of preference or indifference.

Utility is not additive but comparative.

Indifference Curve Analysis (J.R. Hicks and R.G.D. Allen )

Indifference curve: Locus of points which show the different combinations

of two commodities among which the consumer is indifferent, i.e. derives

same utility.

Since all these points render equal utility to the consumer, an

indifference curve is also known as an isoutility (“iso” meaning equal)

curve.

Indifference map: group of indifference curves

Ordinal Utility Analysis

Properties of Indifference Curves

Indifference curves are downward sloping. This is because of the assumption of non-

satiation Higher indifference curve represents higher

utility Indifference curves can never intersect Indifference curves are convex to the origin.

This is because two goods cannot be perfect substitutes of each other

X

Y

D

A

B

O

C

Good X

Go

od

Y

IC2

IC1

Exceptional Shapes of Indifference Curves

QX

QY

OQX

QY

O

QX

QY

OQX

QY

O

Social Bads

Perfect Substitutes

Perfect Complements

Irrational Behaviour

MRS is the proportion of one good (M) that the consumer would be willing to give up for more of another (N)

MRS is the ratio between rates of change in M and N, down the indifference curve :

…..(1)

To increase consumption of M, the consumer has to reduce consumption of N and hence the negative sign. MRSMN goes on diminishing as we move down the indifference curve.

Gain in utility due to consumption of more units of one commodity must be equal to the loss in utility due to consumption of less units of the other commodity

…..(2)

…..(3)

Diminishing Marginal Rate of Substitution

M

NMRSMN

MNN

M MRSMUMU

MN

MUMU

N

M

Consumer’s Equilibrium

Budget line of a consumer, consists of all possible combinations of the two commodities that the consumer can purchase with a limited budget:

Budget constraint depends upon income of the consumer and prices of the commodities in the consumption basket.

Consumer would reach equilibrium point, i.e. highest level of satisfaction given all constraints at the highest indifference curve he/she can reach.

Mathematically

PM.QM+PN.QN=I

(Where PM is price of commodity M, QM quantity of M, PN price of N, QN

quantity of M and I is income of the consumer.

Budget constraint to the consumer includes income of the consumer and prices of the commodities in the consumption basket. A change in any of these constraints would lead to a shift in the budget line. Such a shift can be of three types: upwards, downwards and swivelling.

The consumer will be at equilibrium at a point where the budget line is tangent to the highest attainable indifference curve.

According to the theory of revealed preferences, demand for a commodity by a consumer can be ascertained by observing the buying pattern of the consumer.

Consumer surplus is equal to the difference between the price a consumer is willing to pay and the price he/she actually pays for a commodity.


Conditions for consumer’s equilibrium:

Consumer spends all income in buying the two commodities; hence point of

equilibrium will always lie on the budget line.

Point of equilibrium will always be on the highest possible indifference curve the

consumer can reach with the given budget line.

Consumer is able to maximize utility at a point where the budget line is tangent to an

indifference curve

This is the highest possible curve attainable by the consumer, subject to budget

constraint.

Budget line may

shift either upwards or downwards due to any change in income of the consumer while

price of the commodities remaining same


Quantity of M

Quantity of N

O QM

QN

A

B

E

IC4

IC3

IC1

IC2

C

D

Feasible set is the area OAB, and area beyond budget line AB is infeasible area; therefore IC4 is beyond

reach of the consumer.

Equilibrium is attained at point E where the AB is tangent to curve IC3 (highest attainable

indifference curve).

Point C and B are attainable but on lower indifference curve.

Equilibrium quantities of commodities M and N are QM and QN.

Indifference curves analysis had limitations in terms of its highly theoretical

structure and simplifying assumptions.

Samuelson came up with an approach to assessing consumer behaviour and

introduced the term ‘revealed preference’. The basic hypothesis of the

theory is ‘choice reveals preference’.

Demand for a commodity by a consumer can be ascertained by observing

the actual behaviour of the consumer in the market in various price and

income situations.

This gives us a demand curve for an individual consumer on the basis of

observed behaviour.

Demand for any good (or basket of goods) is known to always increase

when money income alone rises hence it must shrink when price alone rises.

Revealed Preference Theory

Revealed Preference Theory

A

B

CN

M B’

A1

B1

Quantity of M

Quantity of N

O

D

L

R

AB is the budget line. OAB is the feasible set, given the price and income constraints. If out of all the possible combinations of two goods M and N, the consumers chooses

C, it may be deduced that the consumer has revealed his/her preference for C over all other possible combinations (say D, L, R)

Consumer Surplus

The difference between the price consumers are willing to pay and what

they actually pay is called consumer surplus.

Individual consumer surplus measures the gain that a consumer makes by

purchasing a product at a price lower than what he/she had expected to pay.

In a market the total consumer surplus measures the gain to the society due

to the existence of a market transaction.

Consumer Surplus

Equilibrium market price and quantity are at (P*, Q*)

If there is a customer who is willing to pay as high as P1 but actually pays only P*, the

difference between the two prices (P1 –

P*) represents the surplus of the first consumer.

If a second consumer is willing to pay P2

and actually pays P* gains a surplus of (P2

– P*).

Total consumer surplus in the economy is

given by the triangular area P*DE

S

S

P2

Price

D

D

O

B

AP1

P*

Q1 Q2 Q* Quantity

E

Consumer Surplus

Summary

According to ordinal school, utility cannot be measured in physical units;

it is possible to rank utility derived from various commodities.

Indifference curves are downward sloping and convex to the origin; a

higher indifference curve would represent higher utility and two

indifference curves do not intersect each other.

Marginal Rate of Substitution (MRS) shows the amount of a good that a

consumer would be willing to give up for an additional unit of another

commodity.