Microeconmics
Microeconmics
Microeconmics
PART 1 - INTRODUCTION
1. What is Economics?
Economics is the science of studying how limited resources with alternative usage can be
used to satisfy the wants of a person with priorities. In other words, economics is the science
of making choices.
4. Branches of Economics
Economics is comprised of two branches:
5. Importance of Microeconomics
Microeconomics has many different uses. It enables public leaders to comprehend the
effects of their chosen policies and helps them deal with complex situations like climate
change. Microeconomics is utilized by business organizations to comprehend their
competitive situations and to obtain the capabilities needed to increase profitability
through pricing strategies.
Almost all microeconomic models are based on just three key analytical tools, namely:
• Constrained optimization
• Equilibrium analysis
• Comparative statics
Constrained Optimization
As we studied earlier, economics is the science of making choices with constraints. Constrained
optimization is used when we have to make the deciding the best (optimal) choice, considering
all the limitations or restrictions. Constrained optimization problems can be said to have two
parts, an objective function and a set of constraints. A decision-maker aims to "optimise" an
objective function, or maximise or reduce a relationship. For instance, a customer can wish to
buy products to increase her level of happiness. The relationship that specifies how satisfied she
will be when she purchases any specific set of items in this scenario would be the objective
function. Decision-makers must also be aware of limitations on the options they can really
choose from. These limitations are a reflection of the limited resources available or the reality
that certain decisions can only be taken for other reasons. A constrained optimization problem's
constraints are limits or restrictions placed on the decision-maker.
1. Consider a farmer who wants to construct a rectangle fence for his sheep. He can't afford to
buy more fences because he already has F feet of it. He can, however, select the pen's
measurements, which will be W feet in width and L feet in length. He wants to select the L and
W dimensions that will increase the pen's surface area. Constrained optimization is used to solve
the problem discussed above.
2. Suppose a consumer purchases only two types of goods, food and clothing. The consumer has
to decide how many units of each good to purchase each month. This again is a problem of
constrained optimization.
Equilibrium Analysis
The analysis of equilibrium is a crucial technique in microeconomics and is a notion that is used
in many scientific fields. When exogenous elements remain constant, or when no external force
disturbs the equilibrium, a system is said to be in equilibrium. This state or condition will last
eternally. Imagine a physical system with a ball in a cup, as shown in Figure 2, to demonstrate an
equilibrium. Here, gravity is at work, pulling the ball toward the cup's base. When the ball is
released, a ball that was initially kept at point A will not stay there. Instead, it will oscillate until
it reaches point B. The system is not in balance as a result.
Fig. 2
The same concept can be used to describe equilibrium in economics. In a market where there is
competition, equilibrium is reached when the market clears, or when the quantity available for
sale and the quantity sought by customers are almost exactly equal. For eg, in Fig. 3, when the
price reaches Rs. 40 per Kg, the market for white sugar will clear. Producers will want to sell Qo
Kg at that price, and customers will only want to purchase that quantity. (In graphical terms, as
shown by fig, equilibrium takes place at the intersection of the supply and demand curves). All
buyers who are prepared to spend Rs. 40 per Kg can purchase it, and all sellers who are willing
to do so can find customers. There is no upward or downward pressure on the price, so Rs. 40
may remain that way eternally. In other words, there is a state of equilibrium.
Fig. 3
Comparative Statics
The amount of an endogenous variable (A variable whose value is determined within the
economic system being studied) in an economic model is examined using comparative statics
analysis, which is the third of our major analytical tools. Equilibrium analyses or limited
optimization problems can both benefit from comparative statics analysis. Using comparative
statics, we may compare two snapshots of an economic model to do a "before-and-after"
analysis. Given a set of exogenous variable beginning values, the first snapshot informs us of the
endogenous variable levels. The second snapshot describes how an endogenous variable changes
the level of some exogenous variable (A variable whose value is taken as given in the analysis of
an economic system) has altered in response to an exogenous shock.
Opportunity Cost- It is basically the cost of something that you give up or incur in order to get
another thing. When faced with trade-offs, we make a choice of dropping an option out of all the
options that are provided to us, opportunity cost is basically the cost of the option(s) that we have
dropped or given up.
Marginalism- It is basically concerned with the marginal changes in the outcomes that happen
when we make a decision from different choices. This is something that rational people use to
compare the options that are in front of them and select the one which provides higher marginal
benefits.
An important concept that we learned was Incremental Cost. Goods/services have 2 types of
costs – Fixed Cost (Sunk Cost) and Variable Cost (Incremental Cost). Incremental cost in simple
terms is the cost of producing one extra unit.
The applications of constrained optimization are multiple. This is something we use in our daily
time management or grocery purchasing, in industries it is used to allocate an optimum amount
of resources for producing a certain good/service.
The concept of opportunity and marginal cost is used when we have to make a decision among 2
or more choices, eg. Selecting a college for MBA, deciding whether to purchase a new home or
invest your money etc.
The incremental cost is again used to make decisions, they help us identify whether we will be
making more profit or not if we decide to increase our production. Eg. A CEO deciding whether
to accept a new order or not.
Part 4- Price & other demand elasticities, their application in business decisions
In economics, elasticity is a way to quantify how sensitive one economic variable is to changes
in other variables.
In the context of business and economics, it refers to the extent to which consumers, suppliers,
manufacturers, and suppliers shift supply and demand in response to changes in factors like
income.
Elasticity of demand is primarily divided into three categories based on the various variables that
influence the quantity of a product that is demanded: Price Elasticity of Demand (PED), Cross
Elasticity of Demand (XED), and Income Elasticity of Demand (YED).
1. Price Elasticity of Demand (PED)
The quantity demanded for a product is impacted by changes in commodity prices, whether they
be increased or decreased. For instance, the amount demanded for ceiling fans decreases when
the price increases.
Price Elasticity of Demand is the phrase used to describe how responsively the quantity
demanded is when the price changes (PED).
The mathematical formula given to calculate the Price Elasticity of Demand is:
The result obtained from this formula determines the intensity of the effect of price change on
the quantity demanded for a commodity.
On a demand curve that slopes downward and moves from left to right, PED will decrease
continually. At the center of a linear demand curve, PED equals 1.
Consumer income levels significantly influence the quantity demanded for a product. This can be
appreciated by comparing the products offered in urban markets to those sold in rural markets.
The term "income elasticity of demand”, often known as "YED”, describes how sensitive the
amount requested for a given commodity is to changes in the real incomes of the people who buy
it, holding all other factors constant. Real income is the income generated by an individual after
accounting for inflation.
The formula given to calculate the Income Elasticity of Demand is given as:
There are many competitors in an oligopoly-dominated market. As a result, demand for a product
is not just dependent on its own price; other goods' pricing also have an impact.
Cross Elasticity of Demand, abbreviated as XED, is a term used to describe how sensitively the
quantity of one commodity (X) is desired in response to a change in the price of another good
(Y). For this reason, it is also known as Cross-Price Elasticity of Demand.
The formula given to calculate the Cross Elasticity of Demand is given as:
XED = (% Change in Quantity Demanded for one good (X)%) / (Change in Price of
another Good (Y))
The effect of change in economic variables is not always the same on the quantity demanded for
a product.
The demand for a product can be elastic, inelastic, or unitary, depending on the rate of change in
the demand with respect to the change in the price of a product.
We can further classify elasticity on the basis of the amount of fluctuation shown in the quantity
demanded of a good:
A completely elastic demand is one that changes dramatically as a result of a change in the
commodity's price.
When demand is perfectly elastic, even a slight price increase can cause it to fall to zero, whereas
a small price decrease can cause it to climb to infinity.
A theory of economics called elasticity has an impact on business. Therefore, companies must
know whether their products or services are elastic or inelastic. This assists them in developing
business plans and in marketing those products or services.
Businesses that offer products with high elasticities face price competition from rival companies,
and in order to stay afloat, they must conduct a large number of sales transactions.
Conversely, businesses that sell inelastic, must-have commodities, have the luxury of raising
prices without worrying about a decline in demand or sales.
The price elasticity of a good also has an impact on a company's client retention rates. Every
company aims to sell products or services with inflexible demand because doing so would
eventually boost the client retention rate. Even in the event of a price increase, the consumer will
continue to be devoted to the company and purchase the products/services.
The price elasticity of demand aids a business in determining the cost of its goods under various
conditions.
1. Assuming Monopoly:
This relates to the fact that in monopolistic market circumstances, a product's price is solely
decided by the price elasticity of demand. If the market is monopolistic and the demand is
elastic, the price of each unit of the product is set extremely low.
2. Price Discrimination:
Price Dicrimination refers to a situation when different prices are charged from different
consumers. A monopolist, for instance, imposes higher pricing on customers whose demand for
goods is inelastic. This suggests that high costs are imposed on consumers whose demand is
constant regardless of product price changes. A monopolist, on the other hand, levies lower
prices from customers whose demand is elastic.
For instance, whereas the demand for industrial electricity is elastic, it is not elastic for
household consumers, resulting in a high price for domestic electricity. This is so that alternative
fuels can be used in place of electricity for industrial applications. As a result, industrial
electricity is less expensive than home electricity.
3. Formulation of Government Policies:
This relates to the concept of price elasticity of demand and its significance. When deciding how
much to tax people, the government takes price elasticity of demand into account. For instance,
taxes on goods with elastic demand produce less money for the government since the taxes raise
the price of the goods, which lowers demand.
On the other hand, goods with inelastic demand are subject to a high rate of taxation. In addition,
the government takes demand price elasticity into account before enacting any price control
measures.
4. Taxation:
The idea can also be used as a tool in taxation. For taxation purposes, a finance minister must
take the elasticity of the demand for various commodities into account. He risks making the
overall tax yield even lower than before if he raises commodity tax (excise duty) rates too much.
On the other hand, a little tax cut might boost the amount of taxes collected.
Therefore, the government will need to take the elasticity of the demand of the relevant good into
account before imposing a tax or increasing an existing tax's rate. It can generate more money by
taxing goods with inelastic demand (such as sugar, clothing, kerosene oil, etc.) than by taxing
goods with elastic demand (such as refrigerators, cars, steel furniture, etc.). It so happens because
in the former situation, taxes may increase their prices but their demand and sales would not
decline much; nevertheless, in the later scenario, taxes diminish demand and sales significantly
by raising the prices.
This would represent the Maximum Production frontier as the total amount produced by
both countries in 100 worker hours would be 80 barrels of oil and 70 bushels of corn.