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Subject Business Economics

Paper No and Title 1, Microeconomic Analysis

Module No and Title 1, Introduction

Module Tag BSE_P1_M1

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 1: INTRODUCTION
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Market Analysis
3.1 Demand Curve
3.2 Supply Curve
3.3 Market Equilibrium
3.4 Elasticity of Demand
4. Consumer Behaviour
4.1 Consumer Preferences
4.2 Budget Constraint
4.3 Consumer Choice
5. Objective of the Firm
5.1 The Production Function
5.2 Costs of Production
6. Pricing and Output Decisions under different market structures
6.1 Perfect Competition
6.2 Monopoly
6.3 Monopolistic Competition
6.4 Oligopoly
6.5 Bilateral Monopoly
7. Pricing Strategies
7.1 Marginal Cost Pricing
7.2 Mark-up Pricing
7.3 Price Discrimination
7.4 Factor Pricing
7.5 Peak-Load Pricing
8. Welfare Economics and Market failure
8.1 Welfare Economics: Basic Ideas
8.2 Market Failure
8.2.1 Externalities
8.2.2 Public Goods
8.2.3 Asymmetric Information
9. Summary

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1. Learning Outcomes
After reading this module, you shall be able to

 Gain an insight about microeconomics

 Understand the various concepts of microeconomic theory including consumer choice,
firm’s objectives, their pricing strategies
 Identify the normative issues of welfare in microeconomic theory
 Analyze the various causes of market failure

2. Introduction
Microeconomics is the branch of economics based on the economic behaviour of small economic
units: consumers, firms, workers, savers, individual industries, markets and so on. All economic
decisions are ultimately made by individuals, and the totality of these decisions defines the
economic environment. Consumers decide how much of various goods to purchase, workers
decide what jobs to take, and firms decide how many workers to hire and how much output to
produce. Microeconomics encompasses the factors that influence these choices and the way these
small decisions merge to determine the working of the entire economy.

3. Market Analysis
Most of microeconomic theory involves the study of how individual markets function. Markets
refer to the interplay of all potential buyers and sellers involved in production, sale, or purchase
of a particular good or service. To analyze markets, we need to focus on what factors influence
the decisions of buyers and sellers. Innumerable factors could have an impact, but some are
clearly more important than others. Prices receive special attention. Prices are the result of market
transactions, but they also strongly influence the behaviour of buyers and sellers in every market.

The analysis of buyers relies on demand curves; supply curves depict the behaviour of sellers.

3.1 The Demand Curve

The amount of a good that any consumer wishes to purchase depends on many factors: price of
the good, income, age, price of related goods, tastes, etc. A demand curve focuses on the effect of
changes in price, with other factors held constant.
According to the law of demand, ceteris paribus, the lower the price of a good, the larger
the quantity consumers wish to purchase. The negative slope of the demand curve—higher prices
associated with lower quantities—is the graphical representation of the law of demand (Figure
3.1A).
When there is a change in incomes, prices of related goods, or preferences that affects the
quantities demanded at each possible price, it causes a shift in demand. For example, an increase
in income may lead to a rightward shift in demand curve as depicted in Figure 3.1B.

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FIGURE 3.1A: DEMAND CURVE FIGURE 3.1B: SHIFT IN DEMAND

3.2 The Supply Curve

The amount firms offer for sale depends on many factors—price of the good, state of technology,
cost and productivity of the inputs required for production, and so on. The supply curve shows the
quantity of goods producers will be willing to sell at alternative prices. It generally slopes
upwards (Figure 3.2A) indicating that output will increase at a higher price.
A shift in the supply curve arises when the underlying factors influencing the supply, like
technology, prices of inputs, change. As shown in Figure 3.2B, a technological change causes the
supply curve to shift to the right.

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FIGURE 3.2A: SUPPLY CURVE FIGURE 3.2B: SHIFT IN SUPPLY

3.3 Market Equilibrium

The demand curve shows what consumers wish to purchase at various prices, and the supply
curve shows what producers wish to sell. When the two are put together, there is only one price at
which the quantity consumers wish to purchase exactly equals the quantity firms wish to sell. The
intersection identifies the equilibrium price and quantity in the market. A basic conclusion of
microeconomic theory is that market forces left to themselves will tend to establish the
equilibrium price and quantity. As illustrated in Figure 3.3, e is the equilibrium point, at price P
and quantity Q.

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FIGURE 3.3: MARKET EQUILIBRIUM

3.4 Elasticity of Demand

Elasticity measures the sensitivity of one variable to another. The price elasticity of demand
measures the percentage change in quantity demanded resulting from a one percent increase in
price of that good. It is denoted by, ep:
ep = (%∆Q)/ (%∆P)
The percentage change in a variable is the absolute change in the variable divided by the original
level of the variable. In other words,
ep = (∆Q/Q)/ (∆P/P)
The price elasticity of demand is usually a negative number. When the price of a good increases
the quantity demanded usually falls. Thus ∆Q/∆P is negative, as is ep.
When the price elasticity is greater than one, demand is price elastic, because the
percentage decline in quantity demanded is greater than the percentage increase in price. If the
price elasticity is less than one in magnitude, demand is said to be price inelastic. In general, the
price elasticity of demand for a good depends on the availability of other goods that can be
substituted for it. When there are close substitutes, a price increase will cause the consumer to
buy less of the good and more of the substitute. Demand will then be highly price elastic. When
there are no close substitutes, demand will tend to be price inelastic.

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4. Consumer Behaviour
The theory of consumer behaviour explains the principles underlying consumer demand. We
study how consumers make consumption decisions, and how their preferences and budget
constraints determine their demand for various goods.

4.1 Consumer Preferences

The specific market baskets that consumers actually purchase depend on their preferences or
tastes. The theory of consumer behaviour undertakes three basic assumptions about people’s
preferences for one market basket versus another. These are as follows:
 Completeness: Preferences are assumed to be complete, that is, consumers can compare
and rank all possible baskets. Thus, for any two market baskets A and B, a consumer will
prefer A to B, will prefer B to A, or will be indifferent between the two.
 Transitivity: Preferences are transitive. Transitivity means that if a consumer prefers
basket A to basket B and basket B to basket C, then the consumer also prefers A to C.
 More is better than less: Goods are assumed to be desirable. Consumers always prefer
more of any good to less. In addition, consumers are never satisfied or satiated; more is
always better.
These three assumptions form the basis of consumer theory. They impose a degree of rationality
and reasonableness on consumer preferences.
Consumer preferences can be graphically illustrated through indifference curves. An
indifference curve represents all combinations of market baskets that provide a consumer with the
same level of satisfaction (Figure 4.1). It is downward sloping and convex to the origin, given
diminishing marginal rate of substitution between any two goods. A utility function (measure that
assigns a level of utility to individual market baskets) can be represented by a set of indifference
curves. Figure 4.1 shows three indifference curves (with different utility levels – U3 > U2> U1)
associated with a particular utility function.

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FIGURE 4.1: INDIFFERENCE CURVES

4.2 Budget Constraint

So far, we have focused on the first element of consumer theory – consumer preferences. Now we
turn to the second element – the budget constraints that consumers face as a result of their limited
incomes. The budget line indicates all combinations of goods for which the total amount of
money spent is equal to income.
Consider two goods x and y. Given the consumer’s income as M and prices of the two
goods as Px and Py respectively, the budget line represents the following budget constraint:

Px x + Py y = M

The budget line (Figure 4.2) is a downward sloping straight line with a constant negative slope
equal to the price ratio (Px /Py). The magnitude of the slope tells us the rate at which the two
goods can be substituted for each other without changing the total amount of money spent.

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FIGURE 4.2: BUDGET LINE

4.3 Consumer Choice

Given preferences and budget constraints, consumer’s choice of different goods can be
determined. It is assumed that consumers make this choice in a rational way – which they choose
goods to maximize the satisfaction they can achieve, given the limited budget available to them.
The maximizing market basket must satisfy two conditions:
 It must be located on the budget line.
 It must give the consumer the most preferred combination of goods and services.
As illustrated in Figure 4.3, the consumer maximizes satisfaction by choosing point E. This point
is the consumer’s equilibrium point. At this point, the budget line and indifference curve U2 are
tangent and no higher level of satisfaction (like D) can be attained. At E, equilibrium point, the
marginal rate of substitution (MRS) between the two goods equals the price ratio. At C, however,
because the MRS is greater than the price ratio, satisfaction is not maximized.
Thus at the consumer’s equilibrium,
MRS = Px / Py

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FIGURE 4.3: CONSUMER EQUILIBRIUM

5. Objective of the Firm

The theory of the firm focuses on the supply side of the market. It examines the behaviour of
producers, how firms can produce efficiently and how their costs of production change with
changes in both input prices and the level of output.

5.1 The Production Function

The production function summarizes the characteristics of existing technology. It is a relationship

between inputs and output: it identifies the maximum quantity of a commodity that can be
produced per time period by each specific combination of inputs. It is denoted as:
Q = f (K,L)
Where Q is the output, K is the units of capital, and L is the units of labour used in production of
Q.

The production function is illustrated in Figure 5.1. The curve shows the relation between Q and
L for given K. As labour increases, ceteris paribus, output increases. The slope of this total
product curve is the marginal product of labour. The marginal product of labour is defined as the
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change in output resulting from a change in labour, keeping all other factors constant.
Correspondingly, average product is the total output per unit of labour. Thus
MPL = ∂Q/∂L; APL = Q/L

As depicted in Figure 5.1, average and marginal product curves increase at low levels of
employment of labour, reach a maximum, and then decline. Also, when marginal product is
greater than average product, average product is increasing; and when marginal product is less
than average product, average product is decreasing. They both are equal when average product is
at a maximum. The relationship between the total product curve and marginal product is also
important. As long as marginal product is positive, total product will continue to rise, and vice
versa. When marginal product is zero, total product reaches its maximum.

FIGURE 5.1: PRODUCTION FUNCTION

The shapes of these curves reflect the law of variable proportions. The law states that as
the amount of some input is increased in equal increments, while technology and other inputs are
held constant, the resulting increments in output will decrease beyond some point.

5.2 Costs of Production

A firm’s costs are determined by its production function. The law of variable proportion
determines the way the variable cost varies with output. Figure 5.2A depicts the various short run
cost curves—average total cost and marginal cost.

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FIGURE 5.2A: SHORT RUN COST CURVES FIGURE 5.2B: LONG RUN COST
CURVE

The average and marginal costs are U-shaped curves. When marginal cost is below average cost,
average cost declines, and vice versa. When average cost is at a minimum, marginal cost is equal
to average cost.
The long run average cost curve is an envelope of short run cost curves (Figure 5.2B). It
is the lowest average cost attainable when all inputs are variable. It is also a U-shaped curve,
depicting economies and diseconomies of scale. The minimum point of the long run average cost
curve corresponds to the optimum level of output, at which the capacity is fully utilized.
Many firms produce more than one product, which may be closely linked to one another.
In such cases, a firm is likely to enjoy production or cost advantages. Two situations can arise—
economies of scope and diseconomies of scope. Economies of scope are present when the joint
output of a single firm is greater than the output that could be achieved by two different firms
each producing a single product. In contrast, if a firm’s joint output is less than that which could
be achieved by separate firms, then its production process involves diseconomies of scope.

6. Pricing and Output Decisions under Different Market Structures

6.1 Perfect Competition

In perfect competition, there are a very large number of firms in the industry and the product is
homogeneous. Competition is perfect in the sense that every firm considers that it can sell any
amount of output it wishes at the going market price, which cannot be affected by the individual
producer whose share in the market is very small. Thus although competition is perfect, there is
no rivalry among the individual firms. Each firm decides its level of output ignoring the others in
the industry. The products of the firms are perfect substitutes for one another so that the price-
elasticity of the demand curve of the individual firm is infinite. Entry is free and easy.

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6.2 Monopoly

In a monopoly situation there is only one firm in the industry and there are no close substitutes
for the product of the monopolist. The demand of the monopolist coincides with the industry
demand, which has finite price elasticity. Entry is blockaded.

6.3 Monopolistic Competition

In a market of monopolistic competition there are a very large number of firms, but their product
is somewhat differentiated. Hence the demand of the individual firm has a negative slope, but its
price elasticity is high due to the existence of the close substitutes produced by the other firms in
the industry. Despite the existence of close substitutes each firm acts atomistically, ignoring the
competitors’ reactions, because there are too many of them and each one would be very little
affected by the actions of any other competitor. Thus each seller thinks that he would keep some
of his customers if he raised his price, and he could increase his sales, but not much, if he lowered
his price: his demand curve has a high price elasticity, but is not perfectly elastic because of the
attachment of customers to the slightly differentiated product he offers. Entry is free and easy in
the industry.

6.4 Oligopoly

Oligopoly is an industry structure characterized by a few large firms producing most, or all, of
the output of some product. Examples include automobiles, steel, electrical equipment industries,
etc. The characteristic of oligopoly that distinguishes it from other forms of market structures is
the mutual interdependence of firms in the industry. Because there are only a few firms, each
realizes its actions will affect its rivals. Therefore, any price or output decision a firm makes must
be made with the thought of its rivals in mind and with some sort of guess about how rivals will
respond. Since firms can never be sure how rivals will react, they will make decisions in the
presence of uncertainty.
The nature of an oligopolistic industry makes it impossible for economists to develop a
single model that is applicable to all industries exhibiting oligopolistic characteristics. Instead,
economists have developed several theories of oligopoly, each with different behavioral
assumptions about how an oligopolist believes its rivals will react and how they actually do react.
The implications of these models vary since the assumptions made about rival behaviour differ,
and when the assumptions vary, more outcomes become possible.
Oligopoly models have been broadly differentiated as Non-collusive models of Cournot,
Bertrand, Stackelberg, Chamberlin, Sweezy; and Collusive models like Cartels, Price Leadership.
Non-collusive oligopoly is a market where firms work independently and strategically by
recognizing the mutual interdependence; whereas collusive oligopoly is one where firms
maximize their joint profits by entering into a collusive agreement to restrict competition and to
avoid uncertainties arising from oligopolistic interdependence.

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6.5 Bilateral Monopoly

Bilateral monopoly is a market consisting of a single seller (monopolist) and a single buyer
(monopsonist). For example, if a single firm produced all the copper in a country and if only one
firm used this metal, the copper market would be a bilateral monopoly market. The equilibrium in
such a market cannot be determined by the traditional tools of demand and supply. Economic
analysis can only define the range within which the price will eventually be settled. The precise
level of the price (and output), however, will ultimately be defined by non-economic factors, such
as the bargaining power, skill and other strategies of the participant firms. Under conditions of
bilateral monopoly economic analysis leads to indeterminacy which is finally resolved by
exogenous factors.

7. Pricing Strategies
Price theory pertains to the determination of prices of goods and services by firms. It is based not
only on the cost of the product, but also on profit margin and a holistic view of the market and
future viability. A range of pricing strategies can be employed by a business firm when selling a
good or service. These include marginal cost pricing, mark-up pricing, price discrimination,
factor pricing, and peak-load pricing.

7.1 Marginal Cost Pricing

Marginal-cost pricing is a pricing technique in which the price of a product is set equal to its
marginal cost, i.e., the extra cost of producing an extra unit of output. By this policy, a producer
charges for each product unit sold, only the addition to total cost resulting from materials and
direct labour.

7.2 Mark-up Pricing

Mark up pricing is a strategy firms use to maximize profits. In this method, the firm estimates the
average cost of production and then adds a predetermined (agreed) percentage mark up or profit
margin.

7.3 Price Discrimination

Price discrimination is a pricing technique where firms charge different prices to different groups
of buyers for identical or similar goods or services. It exists when a firm has market power and
can prevent or limit arbitrage, and when consumers differ in their demands for a given good or
service.

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7.4 Factor Pricing

Factor pricing theory is concerned with the evaluation of the services of the factors of production.
It deals with the determination of the prices of four factors of production, i.e., land, labour, capital
and entrepreneur.

7.5 Peak-load Pricing

It is a method of pricing in which at the time of peak demand prices rise to balance demand and
supply. Such a pricing strategy is an attempt to shift demand to accommodate supply. Pricing
higher when demand is at its peak will balance out the supply and demand so that there is no
shortage on either end.

8. Welfare Economics and Market Failure

8.1 Welfare Economics: Basic Ideas

Microeconomic theory also deals with normative issues, which is studied as a separate branch,
that is, welfare economics. Welfare economics deals with the way various economic
arrangements affect the welfare or well-being, of all members of society.
There are two fundamental theorems of welfare economics. The First Welfare theorem
states that the equilibrium in a set of competitive markets is Pareto efficient. According to the
Second theorem of Welfare Economics, as long as preferences are convex, then every Pareto
efficient allocation can be supported as a competitive equilibrium.
Economists often use social welfare functions of one kind or another to represent
distributional judgments about allocations. As long as the social welfare function is increasing in
each individual’s utility, a welfare maximum will be Pareto efficient. Furthermore, every Pareto
efficient allocation can be thought of as maximizing some social welfare function.

8.2 Market Failure

In some situations, even competitive markets are not capable of producing efficient outcomes.
There may exist another plausible outcome where a person in the market can be made better-off
without making someone else worse-off. Such a situation is described as market failure.
Market failure arises when freely functioning markets, are unable to provide an efficient
allocation of resources. This is because there is a divergence between private benefits and social
benefits (benefits of the society as a whole) that arises from carrying out a particular activity.
Some important causes of market failure are presence of externalities, public goods, and
imperfect information.

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8.2.1 EXTERNALITIES

Externalities are the harmful or beneficial effects of activities that are borne by people who are
not directly involved in the market exchanges. If externalities are present, the outcome of a
competitive market is unlikely to be Pareto efficient. However, government intervention and the
legal system can ensure that property rights are well defined, so that efficiency enhancing trades
can be made.
If preferences are quasilinear, the efficient amount of a consumption externality will be
independent of the assignment of property rights. Cures for production externalities include the
use of Pigouvian taxes, setting up a market for the externality, or allowing firms to merge.

8.2.2 PUBLIC GOODS

Public goods are goods which are non-rival and non-excludable in nature. They are goods for
which everyone must consume the same amount, such as national defense, air pollution, and so
on. The free rider problem is associated with this type of goods, which refers to the temptation of
individuals to let others provide the public goods. In general, purely individualistic mechanisms
will not generate the optimal amount of a public good because of this free rider problem. Various
collective decision methods have been proposed to determine the supply of a public good. Such
methods include the command mechanism, voting, and Vickrey-Clarke-Groves auction
mechanism.

8.2.3 ASYMMETRIC INFORMATION

Markets fail to perform when there is asymmetric information. Asymmetric information is a

situation where one side in a transaction has more information than the other side. It can arise
from a hidden action, an action that one side can take, but which cannot be observed by the other
side. In situations of hidden actions, it is likely that the more informed side will indulge in wrong
actions, leading to the problem of moral hazard. In the presence of moral hazards, the more
informed side or the insured person tends to undertake low levels of preventive care, leading to
inefficiency in pricing. To cope up with the problem of moral hazard, insurance companies carry
out different practices in the form of co-insurance and deductable. This helps in reducing the
intensity of moral hazard.
The asymmetry in information can also arise from hidden characteristics, wherein one party
knows some characteristics which the other party would like to know, but does not know. Hidden
characteristics lead to situations where the type of the agents is not observable so that one side of
the market has to guess the type or quality of a product based on the behaviour of the other side of
the market. This leads to the problem of adverse selection. In markets involving adverse selection
too little trade may take place. A buyer of a car gets to trade with sellers of bad cars only; a health
insurance company gets to trade with only unwell people. In such situations, the informed party
looks for indicators of hidden characteristics called signals, and often use a screening device to
differentiate customers according to their willingness to pay.

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9. Summary
 Microeconomics is a branch of economics that studies the behaviour of individuals and
small economic units in making decisions on the allocation of limited resources.
 It involves the study of how individual markets function. Markets refer to the interplay of
all potential buyers and sellers involved in production, sale, or purchase of a particular
good or service.
 Microeconomic theory examines how these decisions and behaviour affect the supply and
demand for goods and services, which determines prices, and how prices, in turn,
determine the quantity supplied and quantity demanded of goods and services.
 The theory of consumer behaviour explains the principles underlying consumer demand.
It examines how consumers make consumption decisions, and how their preferences and
budget constraints determine their demand for various goods.
 The theory of the firm focuses on the supply side of the market. It studies the behaviour
of producers, how firms can produce efficiently and how their costs of production
change with changes in both input prices and the level of output.
 A range of pricing strategies are employed by a business firm when selling a good or
service. These include marginal cost pricing, mark-up pricing, price discrimination,
factor pricing, and peak-load pricing.
 Microeconomic theory also deals with normative issues, which is studied as a separate
branch, that is, welfare economics. It deals with the way various economic arrangements
affect the welfare or well-being, of all members of society.
 In some situations, even competitive markets are not capable of producing efficient
outcomes. Such a situation is described as market failure.
 The causes of market failure are presence of externalities, public goods, and imperfect
information.

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ECONOMICS MODULE No. 1: INTRODUCTION