Microeconomics – Meaning, Scope, Importance and

Limitations
The two approaches to the study of Economics are Microeconomics &
Macroeconomics. The Great Depression of 1930s saw the development of these two
approaches. The terms were first coined by Ragnar Frisch.

Microeconomics

Definition: Microeconomics is the branch of economics that studies individual

agents and markets. It focuses on the behavior of individuals and firms, the
determination of prices and quantities in specific markets, and how these entities
allocate limited resources. It gives a microscopic view of the working of the economy.

• Key Topics:
o Consumer behavior
o Production and costs
o Market structures (e.g., perfect competition, monopoly)
o Supply and demand
o Price determination
• Example: Analyzing how a specific firm decides the quantity of a product to
produce based on the cost of production and expected consumer demand.

Macroeconomics

Definition: Macroeconomics is the branch of economics that studies the economy

as a whole. It focuses on aggregate indicators and phenomena, such as total national
output, overall employment, inflation, and economic growth.

• Key Topics:
o National income
o Gross Domestic Product (GDP)
o Inflation
o Unemployment
o Fiscal and monetary policy
• Example: Examining the factors that contribute to national economic growth
or the impact of government policies on overall unemployment rates.

Summary Table

Aspect Microeconomics Macroeconomics

Focus Individual markets and agents The economy as a whole
Key Consumer behavior, production, National income, GDP, inflation,
Topics market structures unemployment
Examples Pricing strategy of a firm National economic growth factors
Scope Specific market analysis Aggregate economic analysis
Understand resource allocation and Understand overall economic
Objectives
market mechanisms performance and policies
Microeconomics and macroeconomics together provide a comprehensive
understanding of how economies function on both small and large scales.

Scope of Microeconomics

Microeconomics focuses on the behavior and decisions of individual economic units

such as consumers, firms, and industries. It examines how these entities interact
within markets and allocate scarce resources. The main areas within the scope of
microeconomics include:

1. Consumer Behavior

• Description: Studies how individuals make decisions to allocate their

limited resources (income) among various goods and services to maximize
utility (satisfaction).
• Key Concepts: Utility, demand, budget constraints, consumer equilibrium,
and preferences.
• Example: Analyzing how a consumer decides to spend their income on
different goods based on their preferences and budget.

2. Production and Costs

• Description: Examines how firms decide on the optimal way to produce

goods and services, considering factors like technology, inputs, and cost
minimization.
• Key Concepts: Production functions, short-run and long-run costs,
economies of scale, and efficiency.
• Example: Understanding how a bakery chooses the mix of labor and capital
to minimize costs while producing bread.

3. Market Structures

• Description: Investigates how different market structures (types of markets)

affect the behavior of firms and the outcomes in terms of prices, output, and
efficiency.
• Key Market Structures:
o Perfect Competition: Many firms, homogeneous products.
o Monopoly: One firm dominates the market.
o Oligopoly: Few firms with significant market power.
o Monopolistic Competition: Many firms, differentiated products.
• Example: Comparing pricing strategies and market outcomes between a
perfectly competitive market and a monopolistic market.

4. Price Determination

• Description: Analyzes how prices of goods and services are determined in

various types of markets based on the interaction of supply and demand.
• Key Concepts: Supply and demand curves, equilibrium price, price
elasticity, and shifts in supply and demand.
 • Example: Determining how an increase in consumer preference for electric
cars affects their market price.

5. Factor Markets

• Description: Studies the markets for factors of production (labor, land, and
capital) and how their prices (wages, rent, interest) are determined.
• Key Concepts: Marginal productivity theory, factor demand and supply, and
factor market equilibrium.
• Example: Analyzing how an increase in the demand for skilled labor in the
tech industry affects wages.

6. Welfare Economics

• Description: Evaluates the economic well-being of individuals and society,

focusing on resource allocation efficiency and equity.
• Key Concepts: Consumer and producer surplus, Pareto efficiency, and
market failures.
• Example: Assessing how a subsidy on solar panels impacts consumer welfare
and market efficiency.

7. Public Goods and Externalities

• Description: Examines goods that are non-excludable and non-rivalrous

(public goods) and the impact of external costs or benefits (externalities) on
social welfare.
• Key Concepts: Public goods, free rider problem, positive and negative
externalities, and government intervention.
• Example: Evaluating the effects of pollution from a factory on the health of
nearby residents and possible regulatory measures.

Summary Table

Area of Study Description Key Concepts Example

Decision-making process Utility, demand, How consumers

Consumer
of individuals to budget allocate income
Behavior
maximize utility constraints among various goods

Production
Optimal production How a bakery
Production and functions,
decisions of firms and minimizes costs while
Costs economies of
cost minimization producing bread
scale

Perfect Pricing strategies in a

Different types of
Market competition, monopolistic market
markets and their impact
Structures monopoly, vs. a competitive
on prices and output
oligopoly market
Area of Study Description Key Concepts Example

Supply and Price changes in the

Price How prices are set in
demand, market for electric
Determination various markets
equilibrium price cars

Markets for labor, land, Wages, rent,

Wage determination
Factor Markets and capital and their interest, marginal
in the tech industry
price determination productivity

Economic well-being and Consumer and Impact of solar panel

Welfare
efficiency of resource producer surplus, subsidies on
Economics
allocation market failures consumer welfare

Goods that are non-

Public goods,
Public Goods excludable and non- Regulation to
externalities,
and rivalrous and the impact mitigate pollution
government
Externalities of external costs or from a factory
intervention
benefits

The systematic study of choice making behaviour of consumers and producers,

allocation of resources between goods, and services, and the determination of prices
make the central theme of microeconomics.
Individuals and households as consumers make choices between various goods and
services they want to consume. The study of consumer behaviour makes the theory of
consumption or the theory of demand.
Individuals, Individual firms make their choices about what to produce and how to
produce it. The study of producers’ behaviour makes the theory of production or the
theory of supply including cost theory.
Theory of demand and theory of supply combined together form the theory of price
determination.
The study of the behaviour of factor owners (land, labour, capital owners) make the
theory of distribution or factor price determination. An extension to the distribution
theory is the study of what kind of allocation of resources between goods and services
makes the distribution most efficient. This is the study of economic welfare.
Importance/Uses of Microeconomics
1. Microeconomics is an important method of economic analysis as it tells
us how a free market economy with its millions of consumers and
producers works to decide about the allocations of productive resources
among thousands of goods and services. A clear understanding of the
working of the complex economic system, greater efficiency in control
and management of the economy is possible through microeconomic
study.
2. The main challenge nations face is of efficient allocation of scarce
resources among competing needs. Microeconomics helps in efficient
employment of the scarce resources as it states the conditions for
efficient allocation, and measures to eliminate inefficiency, and
maximize social welfare. E.g. Pareto Optimality principle.
3. Microeconomic theories establish cause and effect relationships
between two or more economic events, and thereby provides the basis
for predicting the future course of economic events. Economic
predictions are of great importance in planning future course of
economic activities by individuals, firms and the government. For
examples, the law of demand states ceteris paribus if price falls demand
increases – this is a conditional prediction but of great importance for
consumers to make adjustments in their spending pattern; for
producers to plan their production and for the government to
formulate policy regarding the price of commodities.
4. Microeconomics contributes in formulating economic policies and
examining the appropriateness and effectiveness of economic policies.
For example, if the government increases the tax on a commodity
without analysing the nature of its demand and supply, tax revenue
may not increase, it may instead decrease. This may also reduce
production and consumption. Microeconomic theories must be applied
to examine the implications and effectiveness of government
institutions.
5. Microeconomics is the basis for Welfare Economics as it provides the
basis for formulating propositions that maximize social welfare. Price
 theories enables efficient utilization of resources leading to maximum
welfare.
6. Microeconomics is the basic foundation of international trade theories.
Microeconomic theories are used to determine the forex rate,
determine gains from trade, etc.

Limitations of Microeconomics
1. Making Assumptions That Are Unrealistic and Do Not Reflect True Economic
Behavior

• Description: Microeconomics often relies on simplified models and

assumptions to analyze complex economic behaviors. These assumptions can
sometimes be unrealistic and fail to capture the intricacies of real-world
economic interactions.
• Example: The assumption of rational behavior, where consumers always
make decisions to maximize their utility, does not account for irrational
behaviors influenced by emotions or social factors.

2. Assumption of Laissez-Faire Economy

• Description: Microeconomic theories often assume a laissez-faire economy,

where markets operate without government intervention. This assumption
overlooks the significant role that governments play in regulating and
stabilizing economies.
• Example: In reality, government policies such as taxes, subsidies, and
regulations can significantly impact market outcomes, which microeconomic
models might not adequately address.

3. Partial Analysis: Microeconomics Only Studies Individuals, Not the Whole

Economy

• Description: Microeconomics focuses on the behavior of individual

consumers, firms, and markets, leading to a partial analysis that does not
account for the broader economic context.
• Example: While microeconomics might analyze the demand for a specific
product, it does not consider how changes in that market impact overall
economic variables like national income or employment levels.

4. What Is True for Individuals May Not Be True for the Economy

• Description: Microeconomic principles derived from individual behavior do

not always apply when aggregated to the economy as a whole, a concept
known as the fallacy of composition.
• Example: While saving money is beneficial for an individual, if everyone
saves more and spends less simultaneously, it can lead to decreased overall
demand, potentially causing an economic recession (paradox of thrift).
5. Certain Problems Are Beyond the Purview of Microeconomics

• Description: Microeconomics cannot adequately address macroeconomic

issues such as inflation, unemployment, and economic growth, which require
a broader analysis of the entire economy.
• Example: Issues like national monetary policy, fiscal policy, and
international trade dynamics fall under the domain of macroeconomics,
highlighting the limited scope of microeconomic analysis.

Positive and Normative Economics

Positive Economics

Definition: Positive economics deals with objective analysis and facts. It describes
and explains economic phenomena without making value judgments. Statements in
positive economics can be tested and validated or refuted by examining evidence.

Examples:

1. Example 1: "An increase in the minimum wage will lead to higher

unemployment among low-skilled workers."
o This statement can be tested by examining employment data before
and after changes in the minimum wage.
2. Example 2: "The inflation rate in Country X was 3% last year."
o This statement can be verified using statistical data from the country’s
economic reports.

Application in Real Life:

• Policy Analysis: Governments use positive economics to predict the

outcomes of policy changes, such as tax adjustments or subsidies.
• Economic Forecasting: Businesses and economists use positive economics
to forecast future economic conditions, such as GDP growth or unemployment
rates.

Normative Economics

Definition: Normative economics involves value judgments about what the

economy should be like or what particular policy actions should be recommended. It
is subjective and based on opinions, beliefs, and preferences, often involving ethical
considerations.

Examples:

1. Example 1: "The government should increase the minimum wage to ensure a

fair standard of living for all workers."
o This statement reflects a value judgment about fairness and living
standards.
2. Example 2: "The government ought to reduce taxes to increase disposable
income and stimulate economic growth."
 o This statement reflects a belief about the benefits of lower taxes on the
economy.

Application in Real Life:

• Policy Advocacy: Politicians and advocacy groups use normative economics

to argue for or against policy measures based on their values and beliefs.
• Public Debate: Normative economics shapes public debate on issues like
income inequality, healthcare, and environmental regulations.

Choosing Between Positive and Normative Economics

When to Use Positive Economics:

• Objective Analysis: When the goal is to understand the cause-and-effect

relationships in the economy without making subjective judgments. For
instance, analyzing the impact of a tax increase on consumer spending.
• Policy Evaluation: When assessing the effectiveness of existing policies or
predicting the outcomes of proposed policies based on empirical evidence. For
example, evaluating the effects of a new trade agreement on import and export
volumes.

When to Use Normative Economics:

• Value-Based Decisions: When making decisions that involve ethical

considerations or societal values. For example, deciding whether to
implement a universal basic income.
• Setting Goals and Priorities: When establishing economic goals and
priorities that reflect societal preferences and values. For instance, deciding
on the allocation of budget resources between defense and education.

How to Choose Between the Two:

• Define the Purpose: Determine if the objective is to analyze facts (positive)

or to make recommendations based on values (normative).
• Gather Evidence: For positive economics, gather and analyze empirical
data. For normative economics, consider ethical perspectives and societal
goals.
• Communicate Clearly: Clearly distinguish between factual analysis and
value-based recommendations to avoid confusion and ensure transparency in
economic discussions.

Notes on the Problem of Scarcity and Choice in

Microeconomics
Introduction to Scarcity and Choice

Microeconomics is the branch of economics that studies individual and firm

behavior in decision-making and the allocation of resources. Two fundamental
concepts in microeconomics are scarcity and choice.
Scarcity

Scarcity refers to the limited nature of society's resources. Since resources are finite,
but human wants are virtually infinite, we must make decisions about how to allocate
these resources effectively.

Examples of Scarcity:

1. Time: Each person has only 24 hours in a day.

2. Money: Individuals have limited income to spend.
3. Natural Resources: There is a limited amount of oil, coal, and other natural
resources.

Choice

Because of scarcity, choices must be made about how to use resources. Every choice
has an opportunity cost, which is the value of the next best alternative that is forgone
when a decision is made.

Examples of Choice:

1. Individual Choices: Deciding whether to spend money on a new phone or

save it for a vacation.
2. Firm Choices: A company deciding whether to invest in new machinery or
spend money on marketing.
3. Government Choices: A government choosing to allocate budget funds to
healthcare instead of education.

The Concept of Opportunity Cost

Opportunity Cost is the cost of the next best alternative that is not chosen. It
represents the benefits that could have been gained by taking a different decision.

Example of Opportunity Cost:

• If a student decides to spend an evening studying for an exam instead of going

out with friends, the opportunity cost is the enjoyment and relaxation they
would have experienced by going out.

The Production Possibility Frontier (PPF)

The Production Possibility Frontier (PPF) is a curve that illustrates the

maximum feasible amount of two commodities that a business can produce when
those items compete for limited resources. The PPF shows the trade-offs between the
two goods.

Example Using PPF:

• Imagine an economy that produces only two goods: robots and pizzas. If all
resources are dedicated to producing robots, the economy produces a
 maximum number of robots but zero pizzas. Conversely, if all resources go
into making pizzas, the economy produces the maximum number of pizzas but
no robots. Points on the PPF represent efficient use of resources, while points
inside the PPF indicate inefficient use, and points outside are unattainable
with current resources.

Trade-Offs and Choices

Trade-offs are the alternatives that we give up when we choose one option over
another. Because resources are limited, choosing more of one thing means getting
less of another.

Example of Trade-Offs:

• A city might have to choose between building a new park or a new school.
Building the park might improve residents' quality of life, but not building the
school could mean larger class sizes and a lower quality of education.

Lionel Robbins' Definition of Economics

Lionel Robbins, a prominent British economist, provided a widely accepted

definition of economics in his 1932 essay, "An Essay on the Nature and Significance
of Economic Science." His definition focuses on the relationship between human
wants and limited resources. According to Robbins, economics is:

"The science which studies human behavior as a relationship between ends and
scarce means which have alternative uses."

This definition highlights several key aspects:

1. Unlimited Wants

• Description: Robbins emphasized that human wants are virtually unlimited.

People have endless desires for goods and services that improve their well-
being and standard of living.
• Example: Individuals may desire various goods such as food, clothing,
housing, education, and entertainment. As soon as one want is satisfied, new
wants emerge, creating a continuous cycle of desires.

2. Scarce Means

• Description: Resources available to satisfy these unlimited wants are scarce.

Scarcity means that there are limited resources (land, labor, capital, and
entrepreneurship) available to fulfill human wants.
• Example: There is a finite amount of natural resources, such as minerals,
water, and land. Additionally, the availability of human labor and capital
(machinery, technology) is also limited.
3. Alternative Uses of Means

• Description: Scarce resources have alternative uses. This means that the
same resource can be used in different ways to produce different goods and
services. Hence, choosing one use over another involves an opportunity cost.
• Example: A piece of land can be used for agriculture, building a factory, or
constructing residential housing. Choosing to use the land for agriculture
means it cannot be used simultaneously for industrial or residential purposes.

4. The Science of Choice

• Description: Because resources are scarce and have alternative uses,

individuals and societies must make choices about how to allocate them
efficiently to satisfy the most pressing wants. Economics is, therefore, the
science of choice.
• Example: A government must decide how to allocate its limited budget
among various needs such as healthcare, education, defense, and
infrastructure. Businesses must choose how to allocate their resources
between production, marketing, and research and development.