Table of Contents
1. Micro Economics: Meaning, Nature, Scope, Importance, Limitations
Meaning
Microeconomics (from the Greek word 'mikros' meaning 'small') is the branch of economics that studies the behavior of **individual economic units** and their interactions in specific markets. It focuses on the "small picture."
Examples of units studied:
- A single consumer (household)
- A single firm (business)
- A single market (e.g., the market for coffee)
- A single industry (e.g., the auto industry)
Nature
Microeconomics is primarily a **theoretical and analytical** science. It uses models and assumptions (like *ceteris paribus* - "all else being equal") to understand how individuals make decisions and how prices are determined. It is often called **"Price Theory"** because its main goal is to explain how the prices of goods, services, and factors of production are determined.
Scope (What does it study?)
- Theory of Consumer Behavior: How a consumer decides what to buy to maximize their satisfaction (utility).
- Theory of the Firm (Production & Cost): How a firm decides what to produce and how to produce it to minimize cost.
- Theory of Market Structures: How prices and output are determined in different markets (e.g., perfect competition, monopoly).
- Factor Pricing: How the prices of factors of production (land, labor, capital) are determined (i.e., rent, wages, interest).
- Welfare Economics: The study of economic efficiency and social welfare.
Importance
- Helps in understanding the working of a free-market economy.
- Provides the basis for business decisions (e.g., pricing, production).
- Serves as the foundation for government policies (e.g., taxation, subsidies).
- Forms the basis for understanding more complex macroeconomic issues.
Limitations
- "Partial Equilibrium" Analysis: It often studies one market in isolation, ignoring the knock-on effects in other markets.
- Unrealistic Assumptions: It relies on assumptions like "perfect competition" and "perfectly rational consumers," which may not hold true in the real world.
- "Fallacy of Composition": What is true for an individual (micro) may not be true for the whole economy (macro). For example, saving is good for one person, but if *everyone* saves, it can cause a recession.
2. Basic Problems of Economics: Scarcity and Choice
The entire field of economics exists because of one fundamental problem: **scarcity**.
Scarcity: The basic economic problem that arises because people have **unlimited wants** but resources are **limited (scarce)**.
Because of scarcity, we cannot have everything we want. This forces us to make a **choice**. Economics is the study of how people, firms, and governments make choices to allocate their scarce resources.
The Three Basic (or Central) Problems of an Economy:
Every society, regardless of its political system, must answer three basic questions:
- What to produce? (Which goods? Cars or tanks? Wheat or computers?)
- How to produce? (Which technology? Labor-intensive (using more workers) or capital-intensive (using more machines)?)
- For whom to produce? (Who gets the goods? How is the national income distributed?)
3. Choice and Opportunity Cost
When you make a choice, you must give up something else. The value of what you give up is the opportunity cost.
Opportunity Cost: The value of the **next-best alternative foregone** when a choice is made.
- Example 1 (Consumer): If you have 10 and you choose to buy a book, you give up the chance to buy a movie ticket. The movie ticket is your opportunity cost.
- Example 2 (Government): If the government spends100 million building a new highway, the opportunity cost is the hospital or school it could have built with that same $100 million.
4. Production Possibility Frontier (PPF)
The **Production Possibility Frontier (PPF)** (or Production Possibility Curve, PPC) is a graph that illustrates the concepts of scarcity, choice, and opportunity cost.
It shows the **maximum combinations of two goods** that an economy can produce, given its available resources and technology.
What the PPF Shows:
- Scarcity: Represented by the boundary itself. Any point *outside* the curve (like Point C) is **unattainable** with current resources.
- Choice: Any point *on* the curve (like Point B) represents a specific choice. To get more of Good B, you must choose to have less of Good A.
- Opportunity Cost:Free
- Economic Growth: Represented by an **outward shift** of the entire PPF curve, which can be caused by new technology or an increase in resources (like labor or capital).
Why is the PPF concave (bowed outwards)?
The PPF is concave because of the **Law of Increasing Opportunity Cost**. As you produce more and more of one good (e.g., Butter), you have to give up *increasingly larger* amounts of the other good (e.g., Guns). This is because resources are not perfectly adaptable. The workers and machines best suited for making Guns are moved last to making Butter, and they are very inefficient at it.
5. Economic Systems
An economic system is the way a society organizes itself to answer the three basic economic questions (What, How, For Whom).
| Feature | Capitalism (Market Economy) | Socialism (Command Economy) | Mixed Economy |
|---|---|---|---|
| Who owns resources? | Private individuals and firms. | The state (government). | Both private and public ownership. |
| How are decisions made? | The **Price Mechanism** (market forces of supply and demand). | **Central Planning Authority** (government planners). | Price mechanism + Government planning and regulation. |
| Main Motive? | Profit. | Social Welfare. | Profit + Social Welfare. |
| Example Countries: | USA, Japan (in theory). | Former USSR, North Korea. | India, UK, France (most real-world economies). |
6. Positive and Normative Economics
| Positive Economics | Normative Economics | |
|---|---|---|
| What is it? | Describes "what is." It deals with facts and objective statements. | Prescribes "what ought to be." It deals with opinions and value judgments. |
| How to test? | Can be tested and verified with data. (It can be true or false). | Cannot be tested or verified. It is a subjective statement. |
| Keywords: | "is", "was", "will be" | "should", "ought to", "must", "fair", "good" |
| Example: | "An increase in the minimum wage *will cause* unemployment to rise." | "The government *should* raise the minimum wage to ensure a 'fair' standard of living." |
7. Market Forces
7.1 Law of Demand
Law of Demand: Ceteris paribus (all else being equal), as the price of a good falls, the quantity demanded for that good rises. And as the price rises, the quantity demanded falls.
This is an inverse relationship, which is why the demand curve slopes downwards.
- Movement vs. Shift:
- A change in price causes a movement *along* the demand curve (called "change in quantity demanded").
- A change in any other factor causes a *shift* of the entire demand curve (called "change in demand").
- Determinants of Demand (Factors that shift the curve):
- Income of consumers: (Increases for *normal goods*, decreases for *inferior goods*).
- Prices of related goods: (Increases for *substitutes* like Coke/Pepsi; decreases for *complements* like car/petrol).
- Tastes and preferences.
- Expectations of future prices.
- Exceptions to the Law of Demand:
- Giffen Goods: Highly inferior goods (e.g., basic staple food for the very poor) where a price rise leads to a rise in demand because the income effect outweighs the substitution effect.
- Veblen Goods (Snob Effect): Luxury goods (e.g., diamonds, Rolex watches) that are demanded *because* they are expensive. A higher price signals higher status.
7.2 Law of Supply
Law of Supply: Ceteris paribus, as the price of a good rises, the quantity supplied of that good rises. And as the price falls, the quantity supplied falls.
This is a direct relationship (higher price = higher profit incentive), which is why the supply curve slopes upwards.
- Determinants of Supply (Factors that shift the curve):
- Input prices (cost of labor, raw materials).
- Technology (better technology shifts supply to the right).
- Taxes and subsidies.
- Expectations of future prices.
7.3 Market Demand, Supply, and Equilibrium
- Market Demand/Supply: The horizontal summation of all individual demand/supply curves in the market.
- Market Equilibrium: The point where the market demand curve intersects the market supply curve.
- At this point, Quantity Demanded = Quantity Supplied.
- This determines the equilibrium price (P*) and equilibrium quantity (Q*).
7.4 Elasticity of Demand and Supply
Elasticity measures the responsiveness (or sensitivity) of one variable to a change in another.
Price Elasticity of Demand (PED): Measures how much quantity demanded responds to a change in price.
PED = (% Change in Quantity Demanded) / (% Change in Price)
| Value | Term | Meaning | Example |
|---|---|---|---|
| |PED| > 1 | Elastic | Quantity is not very responsive to price. | Necessities, goods with no substitutes (e.g., salt, medicine). |
| |PED| = 1 | Unitary Elastic | Quantity changes by the exact same percentage as price. | (Theoretical) |
Price Elasticity of Supply (PES): Measures how much quantity supplied responds to a change in price. The main determinant is time: supply is more elastic in the long run.