Fundamentals of Microeconomics

FUNDAMENTALS OF
MICROECONOMICS
Dr. Nandeesh H.K
Assistant Professor
PG Department of Economics
St.Philomina’s College, Bannimantap
Mysore-015

ECONOMICS
From the Greek words Oikos meaning household
and nomos meaning management
= Household management
The wise production and use of wealth to meet
the demands or needs of the people

 Paul Samuelson (Economics)
“the study of how people and society end up choosing, with or
without use of money, to employ scarce resources that could
have alternative uses to produce various commodities among
various persons and groups in society.”
 Roger Le Roy Miller (Economics, Today and Tomorrow)
“Economics concerns situations in which choices must be
made about how to use limited resources, when to use them
and for what purposes. Resources can be defined as the things
people use to make the commodities they want.”
 Hall and Loeberman (Macroeconomics: Principles and
Applications)
“The study of choice under the condition of scarcity”

 Bernardo Villegas (Guide to Economics for Filipinos)
“A social science that studies and seeks to
allocate scarce human and non-human resources
among alternatives in order to satisfy unlimited
human wants and desires.”
 Gerardo Sicat (Economics)
“a scientific study which deals with how individuals and
society make choices,”
Conclusion
ECONOMICS – is a social science that deals with how people
organize themselves in order to allocate scarce resources in
order to produce goods and services that will satisfy the
unlimited and multiplying wants and needs of man.

 Scarcity- a situation wherein the amount of something
available is insufficient to satisfy the desire for it.
 Resources-The labor, capital, land and natural
resources and entrepreneurship that are used to
produce goods and services.
 Unlimited – without limits, infinite
 Wants –desires

Production is the use of inputs to produce outputs
 Inputs are commodities or services that are used to
produce goods and services
 Outputs are the different goods and services
which come out of production process.
Economics is concerned with
production

 Economics is concerned with DISTRIBUTION
Distribution is the allocation of the total product among members
of society. It is related to the problem of for whom goods and
services are to be produced.
 Economics is concerned with CONSUMPTION
Consumption is the use of a good or service. Consumption is the
ultimate end of economic activity. When there is no consumption,
there will be no need for production and distribution.
 Economics deals with PUBLIC FINANCE
Public Finance is concerned with government expenditures and
revenues. Economics studies how the government raises money
through taxation and borrowing.

Basic problems of an Economy
If there was a perfect match between wants and resources, there would
have been no scarcity, no question of choice and no economic problem.
The problem of choices arising out of limited resources and unlimited
wants is called economic problem.
3 Fundamental Economic Problems.
 What to produce?
500 guns or 500 tones of rice
 How to produce?
Labor intensive technique or capital intensive technique
 For whom to produce?

An economy faces other problems too..
1. The problem of economic efficiency.
2. The problem of full employment of
resources.
3. The problem of economic growth.

TYPES OF AN ECONOMY
1.CENTRALLY PLANNED ECONOMY:
This is type of an economy in which
government has high control and all the
decisions regarding what to produce,how to
produce,for whom to produce are taken by
government. The main motive of this economy
is to do social welfare
2.MARKET ECONOMY: This is an type of
economy in which government has notional or
very low control and all the decisions regarding
what to produce, how to produce , for whom to
produce are taken to maximize profit.
Centrally
planned
economy

3.MIXED ECONOMY:This is type of an economy which has
moderate government control and in which major decisions like
what to produce,how to produce,for whom to produce are taken
jointly by the government and private and the main motive of this
economy is to do social welfare and as well as to maximize profits

CONTROLLED
ECONOMY
1.These economies have very
high government control.
2.The main motive of this
economy is social welfare.
3.Consumer is not soverign
in this economy.
4.Public sector dominate
the role.
MIXED
ECONOMY
1.These economies have
moderate government control.
economy is to do both.
3.Consumer is
soverign in this
economy.
4.Private and public sector
dominate the role.
MARKET
ECONOMY
1.These economies have
notional government control.
economy is to earn profit.
3.Consumer is
soverign in this
economy.
4.Private sector dominate
the role.

Positive Economics:
This is the type of economics which studies the economic
problems related to past,present and future.
The statements of these economics can be verified for truth
and are based on facts and figures.for example:On the eve
of independence indian poverty has great impact on
population than now.so this example is related to past and
it is also a positive statement.
Characteristics are,
1.Based on facts and figures.
2.Verified for truth.
ES
Positive and Normative Economics

Normative Economics :
This is the type of economics which merely study the opinions
of economists regarding economic problem. The statements of
normative economics cannot be verified for truth and are based
on value judgment. for example, poverty alleviation program
should make changes to eradicate poverty, so this is merely a
opinion of economists and it truth.
Characteristics are,
1. Based on value judgment.
2. Related to what ought to be.
ES
Positive and Normative Economics

Deductive and Inductive methods of
Economics
Deductive
• Also called analytical or
abstract prior method.
• Deduction means
inference and conclusions
from the general to the
particular or from the
universal to the
individual.
• This method is very
important to test theory or
hypothesis.
Inductive
• Also called empirical
method.
• Adapted by Historical
school of economics.
• Induction is the process of
reasoning from a part to
the whole, from particular
to general or from
individual to the
universal.

Deductive Method of Economic Analysis:
The deductive method is also named
as analytical, abstract or prior method. The deductive method
consists in deriving conclusions from general truths, takes few
general principles and applies them draw conclusions.
For instance, if we accept the general proposition that man is
entirely motivated by self-interest. In applying the deductive
method of economic analysis, we proceed from general to
particular.
The classical and neo-classical school of economists notably,
Ricardo, Senior, Cairnes, J.S. Mill, Malthus, Marshall, Pigou,
applied the deductive method in their economic investigations.

Steps of Deductive Method:
The main steps involved in deductive logic are as under:
(i) Perception of the problem to be inquired into: In the process of
deriving economic generalizations, the analyst must have a clear and precise
idea of the problem to be inquired into.
(ii) Defining of terms: The next step in this direction is to define clearly the
technical terms used analysis. Further, assumptions made for a theory
should also be precise.
(iii) Deducing hypothesis from the assumptions: The third step in
deriving generalizations is deducing hypothesis from the assumptions taken.
(iv) Testing of hypothesis: Before establishing laws or generalizations,
hypothesis should be verified through direct observations of events in the
rear world and through statistical methods. (Their inverse relationship
between price and quantity demanded of a good is a well established
generalization).

Inductive Method of Economic Analysis:
Inductive method which also called empirical method was adopted by the
“Historical School of Economists". It involves the process of reasoning from
particular facts to general principle.
This method derives economic generalizations on the basis of (i) Experimentations
(ii) Observations and (iii) Statistical methods.
In this method, data is collected about a certain economic phenomenon. These are
systematically arranged and the general conclusions are drawn from them.
For example, we observe 200 persons in the market. We find that nearly 195
persons buy from the cheapest shops, Out of the 5 which remains, 4 persons buy
local products even at higher rate just to patronize their own products, while the
fifth is a fool. From this observation, we can easily draw conclusions that people
like to buy from a cheaper shop unless they are guided by patriotism or they are
devoid of commonsense.

Steps of Inductive Method:
The main steps involved in the application of inductive method
are:
(i) Observation.
(ii) Formation of hypothesis.
(iii) Generalization.
(iv) Verification.

Theory of Consumer Behavior
• Concept of utility Consumer - A consumer is one who buys
goods and services for satisfaction of his wants. Utility - The
want satisfying power of a commodity. Consumption Bundle -
An individual's consumption bundle is the collection of all the
goods and services consumed by that individual.

Consumer Budget
 A budget constraint represents all the combinations of
goods and services that a consumer may purchase given
current prices within his or her given income.
 Consumer Budget states the real income or purchasing
power of the consumer from which he can purchase certain
quantitative bundles of two goods at given price.
 It means, a consumer can purchase only those combinations
(bundles) of goods, which cost less than or equal to his
income.

• Budget Set A budget set or opportunity set includes
all possible consumption bundles that someone can
afford given the prices of goods and the person's
income level.

Budget Line Budget line is a graphical representation of
all possible combinations of two goods which can be
purchased with given income and prices, such that the
cost of each of these combinations is equal to the
money income of the consumer.

Indifference Curve Analysis
An indifference curve is the curve, which
represents all those combinations of two
commodities, which give same level of
satisfaction to a consumer.
Each point on IC represent same level of
satisfaction. Properties of Indifference curve: It
slopes downward to the right.
It is convex to the origin. Two indifference can
never intersect. It never touches any axis. Higher
indifference curve shows higher satisfaction level.

Marginal Rate Of Substitution
• MRS refers to the rate at which the consumer substitute one
good to obtain one more unit of the other good.
• Key points about MRS:
• The slope of the Indifference curve is
MRS = Δy/Δx
•MRS is never constant, it varies over the IC.
•As we move along Indifference Curve,
MRS falls also called Diminishing Marginal rate of
substitution.

Consumer’s Equilibrium Using Indifference
Curve Analysis
• According to indifference Curve Analysis the
conditions required to achieve consumer equilibrium
are:
1. Where the slope of the indifference curve is equal to
the slope of budget line
MRSxy=Px/Py
Slope of IC = Slope of Budget line
2. The indifference curve must be convex to the origin
at the point of tangency.

Approaches Of Utility Analysis
1. Cardinal Utility Approach: It was given by Alfred Marshall.
It refers to the measurement of utility in terms of numbers as
1,2,3, etc. The unit of measurement under this approach is
‘utils’. Example: A basket of oranges offers 10 utils of utility
to a consumer.
2. Ordinal Utility Approach: It was given by Allen and Hicks. It
refers to the measurement of utility in terms of psychological
satisfaction and a consumer can just rank his preference from a
set of most preferred to least preferred bundles.

• Cardinal Utility Analysis Cardinal utility has two concepts:
1. Total Utility 2. Marginal Utility
1. Total Utility: It refers to total satisfaction obtained from the
consumption of all possible units of a commodity.
TUn = U1+ U2+ U3 TUn = MU1+ MU2+ MU3 TUn = ∑MU
2. Marginal Utility (MU) : It is the additional utility derived from
the consumption of one more unit of the given commodity.
MUn = TUn – TUn-i MUn = Change in Total Utility/ Change
in number of units MUx = ΔTUx/ΔQx (When units do not change
in consecutive order)

Law Of Diminishing Marginal Utility
• This law states that ‘as a consumer consumes more and more
units of a specific commodity, utility from the successive units
goes on diminishing’
• Mr H. Gossen was the first to explain this law in 1854.
Assumptions Of LDMU: Rationality: Consumer aims at
maximum utility Constant MU of Money: MU of money for
purchasing goods remains constant Diminishing MU: Utility
falls from successive units Continuous Consumption: No time
gap Income : Income of a consumer remains the same

Demand is defined as the quantity of a commodity that a consumer
is willing and able to purchase in the market Keeping other factors
constant. Example: A consumer demands 5 kg of sugar in a month
at a price of Rs 40/ kg.
Demand can be classifies as:
Individual Demand: Demand of an individual person.
Market Demand: Demand of all the households.
Demand Analysis

The functional relationship between the demand for a commodity
and the factors affecting demand is termed as demand function.
There are 2 types of demand Function:
Individual Demand Function: It shows how demand for a
commodity in the market is related to its factors.
Dx= f(Px,Pr,Y,T,E)
Market Demand Function: It shows how market demand for a
commodity in the market is related to its determinants.
Dx= f(Px,Pr,Y,T,E,N,Dy,Pc)
Demand Function

Demand Function Symbols
Dx = Demand for commodity X
f = Functional relation
Px = Price of the commodity X
Pr = Price of related goods
Y = Consumers’ Income
T = Taste and preferences of consumer
E = Consumers expectation regarding goods
N = Population size
Dy = Distribution of income
Pc = Composition of population

Factors Affecting Demand
1)Price of the commodity[Px]
It means, as price increases, quantity demanded falls due to decrease in
the satisfaction level of consumers.
1)Income of the consumer[Y] Demand for a commodity is also
affected by income of the consumer. However, the effect of change in
income on demand depends on the nature of the commodity under
consideration.
i.If the given commodity is a normal good, then an increase in income
leads to rise in its demand, while a decrease in income reduces the
demand. Example, Full cream milk, grains, etc.
ii.If the given commodity is an inferior good, then an increase in
income reduces the demand, while a decrease in income leads to rise
in demand. Example, Poor quality food, coarse cereals, etc.

3) Price of Related Goods [Pr] Demand for the
given commodity is also affected by change in prices
of the related goods.
Related goods are of two types: Substitute goods and
complementary goods.
i. Substitute Goods -Substitute goods are two goods that
could be used for the same purpose. If the price of one good
increases, then demand for the substitute is likely to rise.
Therefore, substitutes have a positive cross elasticity of
demand.

ii. Complementary Goods: In economics, a
complementary good or complement is a good with a
negative cross elasticity of demand, in contrast to a
substitute good.
This means a good's demand is increased when the
price of another good is decreased. Conversely, the
demand for a good is decreased when the price of
another good is increased.

4)Taste and Preferences[T] Tastes and preferences of
the consumer directly influence the demand for a
commodity. They include changes in fashion, customs,
habits, etc. If a commodity is in fashion or is preferred
by the consumers, then demand for such a commodity
rises.
5)Expectations [E] If the price of a certain commodity
is expected to increase in near future, then people will
buy more of that commodity than what they normally
buy. For example, if the price of petrol is expected to
rise in future, its present demand will increase.

6)Distribution of Income [Dy] In case of equal
distribution, demand from all sections of society will
rise.
7)Size of Population [N] Higher population
implies greater market demand.
8)Composition of Population[Pc] If population of a
country has greater percentage of youth, then market
demand for branded clothes, bikes, etc rises.

Demand Schedule & Demand Curve
The tabular presentation of price and quantity demanded is
called demand schedule and a demand curve is the graphical
representation of the demand schedule.
Its is of two types:
1. Individual Demand Schedule and its Curve
2. Market Demand Schedule and its Curve

Individual Demand Schedule and Its Curve

Market Demand Schedule and its Curve

Law of Demand
The law of demand states that other factors being constant (cetris
peribus), price and quantity demand of any good and service are
inversely related to each other. When the price of a product
increases, the demand for the same product will fall.

Assumptions Of the Law of Demand
1. Taste and preferences of the consumers remain constant.
2. There is no change in the income of the consumers.
3. Prices of the related goods do not change.
4. No expectation of further changes in the supply of a
commodity.
5. No change in the distribution of income.
6. No change in population.

Exceptions to the Law of Demand
• Giffen Goods : A good where higher price causes an increase
in demand (reversing the usual law of demand). The increase in
demand is due to the income effect of the higher price
outweighing the substitution effect.
• The idea is that if you are very poor and the price of your basic
foodstuff (e.g bread) increases, then you can’t afford the more
expensive alternative food (meat) therefore, you end up buying
more bread because it is the only thing you can afford.

Exceptions to the Law of Demand
Conspicuous Consumption/ Veblen Goods : The law of demand
will not apply in case of costly items such as Diamond. These
commodities will be demanded, even if the prices have gone up
very high.
Conspicuous Necessities : Certain commodities are necessities so
even if there price rises the demand does not fall. Example :
Automobiles

Shift In demand Curve or Change in Demand
A shift in the demand curve is caused
by the change in factors other than
the price of the good. It is of two
types Increase in Demand and
Decrease in Demand.

Elasticity of Demand
It refers to the degree of responsiveness in
demand due to change in price of a commodity
or income of the consumer or price of related
goods.
It can be of 3 types:
1. Price Elasticity of Demand
2. Income Elasticity of Demand
3. Cross Elasticity of Demand

Price Elasticity of Demand
Price elasticity of demand (PED or Ed) is a measure to show
the responsiveness, or elasticity, of the quantity demanded of
a good or service to a change in its price, ceteris paribus. It is
a quantitative approach.

Determinants of Price Elasticity of Demand

• Supply and demand are the two words that
economists use most often.
• Supply and demand are the forces that make market
economies work.
• Modern microeconomics is about supply,
demand, and market equilibrium.
Production and Cost Market

• According to the Law of Supply:
– Firms are willing to produce and sell a greater
quantity of a good when the price of the good is
high.
– This results in a supply curve that slopes upward.
• The Firm’s Objective
– The economic goal of the firm is to maximize
profits.

• Total Revenue
– The amount a firm receives for the sale of its output.
• Total Cost
– The market value of the inputs a firm uses in
production.
• Profit
– The firm’s total revenue minus its total cost.
Profit = Total revenue - Total cost

• A firm’s cost of production includes all the
opportunity costs of making its output of goods
and services.
• Explicit and Implicit Costs
–A firm’s cost of production include
explicit costs and implicit costs.
• Explicit costs are input costs that require a direct
outlay of money by the firm.
• Implicit costs are input costs that do not require
an outlay of money by the firm.

• The Production Function
–The production function shows the
relationship between quantity of inputs used
to make a good and the quantity of output of
that good.
• Marginal Product
–The marginal product of any input in the
production process is the increase in output
that arises from an additional unit of that
input.

• Diminishing Marginal Product
–Diminishing marginal product is the property
whereby the marginal product of an input
declines as the quantity of the input increases.
• Example: As more and more workers are hired at a firm,
each additional worker contributes less and less to
production because the firm has a limited amount of
equipment.

0 Number of Workers Hired
Quantityof
Output
(cookiesper
hour)
4
2
1 3 5
50
90
150
140
120
Production
function
Hungry Helen’s Production Function

0
Total Cost
Quantityof
Output
(cookiesper
hour)
50 90 140 120 150
$80
70
60
50
40
30
Total-cost curve
Hungry Helen’s Total-Cost Curve

• Costs of production may be divided into fixed
costs and variable costs.
• Fixed costs are those costs that do not vary
with the quantity of output produced.
• Variable costs are those costs that do vary
with the quantity of output produced.

• Total Costs
–Total Fixed Costs (TFC)
–Total Variable Costs (TVC)
–Total Costs (TC)
–TC = TFC + TVC

• Average Costs
–Average costs can be determined by
dividing the firm’s costs by the
quantity of output it produces.
–The average cost is the cost of
each typical unit of product.

• Average Costs
– Average Fixed Costs (AFC)
= ATC / Q
– Average Variable Costs (AVC)
= AVC / Q
– Average Total Costs (ATC)
= ATC / Q
– ATC = AFC + AVC

• Marginal Cost
– Marginal cost (MC) measures the increase in total
cost that arises from an extra unit of production.
– Marginal cost helps answer the following
question:
• How much does it cost to produce an additional unit of
output?
THE VARIOUS MEASURES OF COST

• Marginal Cost
– Marginal cost (MC) measures the increase in total cost
that arises from an extra unit of production.
– Marginal cost helps answer the following
question:
• How much does it cost to produce an additional
unit of output?
MC
(change in total cost) TC
(change in quantity) Q

• The cost curves shown here for Thirsty
Thelma’s Lemonade Stand have some
features that are common to the cost
curves of many firms in the economy.
• Lets examine three features in particular:
– The shape of the marginal cost curve
– The shape of the average cost curve
– The relationship between marginal and
average total cost

5
0
Costs
3.30
3.00
6 10
Quantity of Output (glasses
of lemonade per hour)
7 8 9
4
3
2
1
1.30
MC
ATC
AVC
AFC
Average-Cost Curve

• Marginal cost rises with the amount of output
produced.
– This reflects the property ofdiminishing
marginal product.
• The average total-cost curve is U-shaped.
• At very low levels of output average total cost is high
because fixed cost is spread over only a few units.
• Average total cost declines as output increases.
• Average total cost starts rising because average
variable cost rises substantially.

• The bottom of the U-shaped ATC curve occurs at the
quantity that minimizes average total cost. This
quantity is sometimes called the efficient scale of the
firm.
• Relationship between Marginal Cost and Average
Total Cost
– Whenever marginal cost is less than average
total cost, average total cost is falling.
– Whenever marginal cost is greater than average
total cost, average total cost is rising.
– The marginal-cost curve crosses the average-
total-cost curve at the efficient scale.

• Economies of scale refer to the property
whereby long-run average total cost falls as
the quantity of output increases.
• Diseconomies of scale refer to the property
whereby long-run average total cost rises as
the quantity of output increases.
• Constant returns to scale refers to the
property whereby long-run average total
cost stays the same as the quantity of output
increases

Fundamentals of Microeconomics

Fundamentals of Microeconomics

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