Chapter 1 Preliminaries
1.1 The themes of microeconomics
Microeconomics deals with the behaviour of individual economic units. There units include consumers, workers,
investors, owners of land, business firms- in fact, any individual or entity that plays a role in the functioning of
our economy. Microeconomics explains how and why these units make economic decisions.
By contrast, macroeconomics deals with aggregate economic quantities, such as the level and growth rate of
national output, interest rates, unemployment, and inflation.
Much of microeconomics is about limits. But microeconomics is also about ways to make the most of these limits.
More precisely, it is about the allocation of scarce resources. Microeconomics describes the trade-offs that
consumers, workers, and firms face, and shows how these trade-offs are best made.
A second important theme of microeconomics is the role of prices. Microeconomics 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 –
collections of buyers and sellers that together determine the price of a good.
In economics as in other sciences, explanation and prediction are bases on theories. Theories are developed to
explain observed phenomena in terms of a set of basic rules and assumptions. A model is mathematical
representation, based on economic theory, of a firm, a market or some other entity.
Microeconomics is concerned with both positive and normative questions. Positive questions deal with
explanation and prediction, normative questions with what ought to be. Positive analysis: statements that
describe relationships of cause and effect. But sometimes we want to go beyond explanation and prediction to
ask such questions as “what is the best?”, this involves normative analysis.
1.2 What is a market?
Together, buyers and sellers interact to form markets. A market is the collection of buyers and sellers that,
through their actual or potential interactions, determine the price of a product or set of products.
An industry is a collection of firms that sell the same or closely related products. In effect, an industry is the
supply side of the market. Economists are often concerned with market definition – with determining which
buyers and sellers should be included in a market.
A perfectly competitive market has many buyers and sellers, so that no single buyer or seller has any impact on
the price. Finally, some markets contain many producers but are non-competitive, that is, individual firms can
jointly affect the price. A cartel is a group of produces that acts collectively.
In a perfectly competitive market, a single price – the market price – will usually prevail. In markets that are not
perfectly competitive, different firms might charge different prices for the same product. In cased such as this,
when we refer to the market price, we will mean the price averaged across brands or supermarkets.
As we saw, market definition identifies which buyers and sellers should be included in a market. However, to
determine which buyers and sellers to include, we must first determine the extent of a market – its boundaries,
both geographically and in terms of the range of products to be included in it.
,Market definitions is important for two reasons:
1. A company must understand who its actual and potential competitors are for the various products that
it sells or might sell in the future.
2. Market definition can be important for public policy decisions.
1.3 Real versus Nominal prices
The nominal price of a good (sometimes called its current-dollar price) is its absolute price. The real price of a
good (sometimes called its constant-dollar price) is the price relative to an aggregate measure of prices. In other
words, it is the price adjusted for inflation. For consumer goods, the aggregate measure of prices most often
used is the consumer price index (CPI).
Sometimes we are interested in the price of raw materials and other intermediate products bought by firms, as
well as in finished products sold at wholesale to retail stores. In this case, the aggregate measure of prices often
used is the producer price index (PPI).
Chapter 2 The Basics of Supply and Demand
2.1 Supply and Demand
The supply curve shows the quantity of a good that producers are willing to sell at a given price, holding constant
any other factors that might affect that might affect the quantity supplied.
➢ Qs = Qs(P)
The higher the price, the more firms are able and willing to produce and sell.
The quantity that producers are willing to sell depends not only on the price they receive but also on their
productions costs, including wages, interest charges, and the costs of raw materials. When production costs
decrease, output increases no matter what the market price happens to be. The entire supply curve thus shifts
to the right, which is shown in the figure as a shift from S to S’.
Economists often use the phrase change in supply to refer to shifts in the supply curve, while reserving the phrase
change in the quantity supplied to apply to movements along the supply curve.
,The demand curve shows how much of a good consumers are willing to buy as the price per unit changes.
➢ Qd = Qd(P)
Goods are substitutes when an increase in the price of one leads to an increase in the quantity demanded of the
other. Goods are complements when an increase in the price of one leads to a decrease in the quantity
demanded for the other.
2.2 The market mechanism
The two curves intersect at the equilibrium, or market-clearing, price and quantity. The market mechanism is
the tendency in a free market for the price to change until the market clears – i.e., until the quantity supplied
and the quantity demanded are equal.
A surplus is a situation in which the quantity supplied exceeds the quantity demanded. A shortage is a situation
in which the quantity demanded exceeds the quantity supplied.
, 2.4 Elasticities of Supply and Demand
An elasticity measures the sensitivity of one variable to another. Specifically, it is a number that tells us the
percentage change that will occur in one variable in response to a 1-percent increase in another variable. We
write price elasticity of demand, 𝐸𝑝 as
∆𝑄 / 𝑄 𝑃 ∆𝑄
➢ 𝐸𝑝 = =
∆𝑃 / 𝑃 𝑄 ∆𝑃
For example, is 𝐸𝑝 = -2, we say that the elasticity is 2 in magnitude. When the price elasticity is greater than 1 in
magnitude, we say that demand is price elastic because the percentage decline in quantity demanded is greater
than the price increase in price. If the price elasticity is less than 1 in magnitude, demand is said to be price
inelastic.
