Chapter 1. Preliminaries
Microeconomics deals with the behavior of individual economic units. These unit include any
individual or entity that plays a role in the functioning of our economy (consumers, workers,
investors, owners of land, business firms, etc.). Microeconomics explains how and why these units
make economic decisions. It also explains how firms decide how many workers to hire and how
workers decide where to work and how much work to do. And how economic units interact to form
lager units- markets and industries. By studying the behavior and interaction of individual firms and
consumers, microeconomics reveals how industries and markets operate and evolve, why they differ
from one another, and how they are affected by government policies and global economic
conditions.
Macroeconomics deals with aggregate economics quantities, interest rates, unemployment,
and inflation. But the boundary between macro- and microeconomics has become less and less
distinct in recent years. The reason is that macroeconomics also involves the analysis of markets. To
understand how these aggregate markets operate, we must first understand the behavior of the
firms, consumers, workers, and investors who constitute them. Thus macroeconomics have become
increasingly concerned with the microeconomics foundations of aggregate economic phenomena,
and much of macroeconomics is actually an extension of microeconomic analysis.
1.1 The Themes of Microeconomics
Much of microeconomics is about limits. It is also about ways to make the most of these limits. More
precisely, it is about the allocation of scarce resources. In a planned economy these allocation
decisions are made mostly by the government . As a result, many of the tools and concepts of
microeconomics are of limited relevance in those countries.
Trade-Offs
Microeconomics describes the trade-offs that consumers, workers, and firms face, and shows how
these trade-offs are best made. Consumers: limited incomes, which can be spent on a wide variety of
goods and services, or saved for the future. Workers: People must decide whether and when to enter
the workforce. Workers face trade-offs in their choice of employment. Workers must decide how
many hours per week they wish to work. Firms: limits in terms of the kinds of products that they can
produce, and the resource available to produce them.
Prices and markets
The trade-offs are based on the prices faced by consumers, workers, or firms. Microeconomics also
describes how prices are determined. In a centrally planned economy, prices are set by the
government. In a market economy, prices are determined by the interactions of consumers, workers,
and firms. These interactions occur in markets.
Theories and models
Economics is concerned with the explanations of observed phenomena. In economics explanation
and prediction are based on theories. Theories are developed to explain observed phenomena in
terms of a set of basic rules and assumptions. It also explains how these choices depend on the prices
of inputs (labor, capital, raw materials) and the prices that firms receive for their outputs.
Economic theories are also the basis for making predictions. Thus the theory of the firm tells
us whether a firm’s output level will increase or decrease in response to an increase in wage rates or
a decrease in the price of raw materials. With the application of statistical and econometric
techniques, theories can be used to construct models form which quantitative predictions can be
made. A model is a mathematical representation, based on economic theory, of a firm, a market, or
some other entity. Statistics and econometric also let us measure the accuracy of our predictions.
Quantifying the accuracy of a prediction can be as important as the prediction itself.
Summary Microeconomics 1
, No theory is perfectly correct. The usefulness and validity of a theory depend on whether it
succeeds in explaining and predicting the set of phenomena that it is intended to explain and predict.
Theories, therefore, are continually tested against observation. As a result of this testing, they are
often modified or refined and occasionally even discarded. The process of testing and refining
theories is central to the development of economics as a science. When evaluating a theory, it is
important to keep in mind that it is invariably imperfect.
Positive versus normative analysis
Positive analysis: Analysis describing relationship of cause and effect.
Normative analysis: Analysis examining questions of what ought to be.
Positive analysis is central to microeconomics. The use of economic theory for prediction is
important both for the managers of firms and for public policy. You need to estimate the impact of a
change. Government policymakers would also need quantitative estimates of effects. They would
want to determine the costs imposed on consumers, the effects on profits and employment, and the
amount of tax revenue likely to be collected each year.
Sometimes we want to go beyond explanation and prediction to ask such questions as ‘What
is the best?’. This involves normative analysis, which is also important both for the managers of firms
and for public policy. Normative analysis is not only concerned with alternative policy options, it also
involves the design of particular policy choices. Normative analysis is often supplemented by value
judgments. When value judgments are involved, microeconomics cannot tell us what the best policy
is. However, it can clarify the trade-offs and thereby help to illuminate the issues and sharpen the
debate.
1.2 What is a Market?
Market: Collection of buyers and sellers, that through their actual or potential interactions,
determine the price of a product or set of product. Note that a market is more than an industry (a
collection of firms that sell the same or closely related products).
Economics are often concerned with market definition: Determining of the buyers, sellers,
and range of products that should be included in a particular market. When defining a market,
potential interactions of buyers and sellers can be just as important as actual ones.
Significant differences in price of a commodity create a potential for arbitrage: practice of
buying at a low price at one location and selling at a higher price in another. Markets are at the
center of economic activity, and many of the most interesting issues concern the functioning of
markets.
Competitive versus noncompetitive markets
Perfectly competitive market: Market with many buyers and sellers, so that no single buyer or seller
has a significant impact on price. Conditions: free entry/exit, homogeneity, no market power,
transparency. Most agricultural markets are close to being perfectly competitive.
Some markets have a small number of producers, but may still be treated as competitive. Some
markets contain many producers but are noncompetitive: individual firms can affect the price.
Market price
Market price: Price prevailing in a competitive market. In markets that are not perfectly competitive,
different firms might charge different prices for the same product. This might happen because one
firm is trying to win customers from its competitors, or because customers have brand loyalties that
allow some firms to charge higher prices than others. The market prices of most goods will fluctuate
over time, and for many goods fluctuations can be rapid. This is particularly true for goods sold in
competitive markets.
Summary Microeconomics 2
