Download Introduction, Basic Principles, Methodology

Introduction
Ashish Pandey
Microeconomics
Economics is the study of those human activities that
determine the production and distribution of goods and
services in society.
Microeconomics is that branch of Economics that attempts
to understand economic activity by studying the behaviour
of the individual decision-makers in the economy.
Much of that economic activity takes place in markets, so
much of Microeconomics is concerned with the functioning
of markets and the determination of market prices.
Two Central Ideas in Microeconomics
• Marshall’s demand–supply cross argues that market prices
are determined by the interaction of the activities of buyers
(the demand side in a market) and suppliers (the supply side
of the market). This idea underlies the branch of
Microeconomics called positive economics.
• The Invisible Hand theorem says that, under certain
conditions, individuals seeking to pursue their own selfinterest nevertheless do what is in the social interest. This
idea underlies the branch of Microeconomics called
normative economics.
Positive and Normative statements
The Economic way of Thinking
 Think on the margin: Rational economic agents think in
terms of the margin rather than the average.
 Think in terms of opportunities: When making decisions,
rational economic agents think in terms of the alternatives,
or foregone opportunities.
 Think in terms of equilibrium: When analyzing a situation,
economists like to think of where it will end up rather than
the details of where it is in the moment, thereby focusing on
the fundamental forces in the situation.
Managerial Economics & Theory
 Managerial economics applies microeconomic theory to business
problems
 How to use economic analysis to make decisions to achieve firm’s
goal of profit maximization
 Microeconomics
 Study of behavior of individual economic agents
Ten Economic Principles for
Managers
No.1 :The Role of Managers is to
Make Decisions
No.2: Decisions are Always Among
Alternatives
No.3: Decision Alternatives Always
Have Costs & Benefits
Total Economic Cost
 Explicit Costs
 Monetary payments to owners of market-supplied resources
 Implicit Costs
 Nonmonetary opportunity costs of using owner-supplied
resources
Types of Implicit Costs
 Opportunity cost of cash provided by owners
 Equity capital
 Opportunity cost of using land or capital owned by the firm
 Opportunity cost of owner’s time spent managing or
working for the firm
No.4: The Anticipated objective of
Management is to increase the Firm’s Value
No.5: Firm’s Value is Measured by
Its Expected Profits
Maximizing the Value of a Firm
 Maximize firm’s value by maximizing profit in each time period
 Value of a firm =
1
(1  r )

2
(1  r )
2
 ... 
T
T
(1  r )
T

t 1
t
(1  r )
t
No.6: The Firm’s Sales Revenue Depends
on Demand for its Product
No.7: The Firm Must Minimize Cost
for Each Level of Output
No.8: The firm Must develop a Strategy
consistent with its Market
Market Structures
 Market characteristics that determine the economic environment
in which a firm operates
 Number & size of firms in market
 Degree of product differentiation
No.9: The Firm’s Growth Depends on
Rational Investment Decisions
No.10: Successful Firms Deal Rationally
and Ethically with Laws and Regulations
Three Key Issues
 What should be produced?
 Efficient Production
 Economic Growth
Production Possibility Frontier
• A production-possibility boundary shows all of the combinations
of goods that can be produced by an economy whose
resources are fully employed.
• Movement from one point to another on the boundary shows
a shift in the amounts of goods being produced, which
requires a reallocation of resources.
A Production-Possibility Boundary
Unattainable combinations
Attainable
combinations
0
Production possibility
boundary
Quantity of public sector goods
Unattainable combinations
a
c0
•d
Production possibility
boundary
C
Attainable
combinations
c1
b
c
0
G
g0
g1
Quantity of public sector goods
A production-possibility boundary
 The quantity of public sector goods produced is measured along the horizontal
axis.
 The quantity of private sector goods is measured along the vertical axis.

 Any point on the diagram indicates some amount of each kind of good
produced.
 The production-possibility boundary separates the attainable combinations, such
as a, b, and c, from unattainable combinations, such as d.
 Points a and b represent efficient uses of society’s resources.
 Point c represents either an inefficient use of resources or a failure to use all the
resources that are available.
A production-possibility boundary
 The boundary is negatively sloped because in a fully employed economy more of
one good can be produced only if resources are freed by producing less of other
goods.

 Moving from point a (with coordinates c0 and g0) to point b (with coordinates c1
and g1) implies producing an additional amount of public sector goods, indicated
by G in the figure
 The opportunity cost of this increase in G is a reduction in private sector goods by
the amount indicated by C.
The effect of economic growth on the production
possibility boundary
 Economic growth shifts the boundary outwards.
 Some combinations of goods that were previously
unattainable become attainable.
The Effect of Economic Growth on the Production-Possibility
Boundary
Production possibility
boundary before growth
0
Quantity of public sector goods
The Effect of Economic Growth on the
Production-Possibility Boundary
a
d
Production possibility
boundary before growth
0
Quantity of public sector goods
Production possibility
boundary after growth
b
Who Makes the Choices and How?
1.
Spending Choices – maximizing decisions, marginal decisions
2.
Production Choices – specialization / division of labour
3. Specialization should be accompanied with trade
 Modern economies are based on the specialization and division of labour, which
necessitate the exchange of goods and services.
 Exchange takes place in markets and is facilitated by the use of money.
 Much of economics is devoted to a study of how markets work to co-ordinate
millions of individual, decentralized decisions.
 Three pure types of economy can be distinguished: traditional, command, and
free market.
 In practice, all economies are mixed economies in that their economic behaviour
responds to mixes of tradition, government command, and price incentives.
Absolute Advantage
Time spent fully
producing one
or the other
Sweaters
Suits
either
or
100
40
either
or
400
10
Peter
Jane
Total
Absolute Advantage
Time spent fully
producing one
or the other
Time divided equally
between producing the
two products
Sweaters
Suits
either
or
100
40
either
or
400
10
Sweaters
Suits
Peter
50
20
200
5
250
25
Jane
Total
Absolute Advantage
Time spent fully
producing one
or the other
Time divided equally
between producing the
two products
Sweaters
Suits
either
or
100
40
either
or
400
10
Sweaters
Suits
Full Specialization
Sweaters
Suits
Peter
50
20
-
40
200
5
400
-
250
25
400
40
Jane
Total
Absolute advantage
 The first columns show that, working full time on his own, Peter can produce




either 100 sweaters or 40 suits per year, whereas Jane can produce 400
sweaters or 10 suits.
Thus Jane has an absolute advantage in producing sweaters and Jacob has an
absolute advantage in producing suits.
The second columns show the outputs if they both spend half their time
producing each commodity.
The third columns show the results when Peter specializes in suits, producing
40 of them, and Jane specializes in sweaters, producing 400.
Sweaters production rises from 250 to 400, while suits production goes from
25 to 40.
Comparative Advantage
Time spent fully
producing one
or the other
Sweaters
Suits
either
or
100
40
either
or
400
48
Peter
Jane
Total
Comparative Advantage
Time spent fully
producing one
or the other
Sweaters
Time divided equally
between producing the
two products
Suits
either
or
100
40
either
or
400
48
Sweaters
Suits
Peter
50
20
200
24
250
44
Jane
Total
Comparative Advantage
Time spent fully
producing one
or the other
Sweaters
Time divided equally
between producing the
two products
Suits
either
or
100
40
either
or
400
48
Sweaters
Suits
Full Specialization
Sweaters
Suits
Peter
50
20
-
40
200
24
300
12
250
44
300
52
Jane
Total
Comparative advantage
 The first columns in the table show that Jane is more productive than Peter in both suits





and sweaters.
Compared with Peter, Jane is 400 per cent more efficient at producing sweaters and 20
per cent more efficient at producing suits.
The second columns give the outputs when Peter and Jane each divide their time equally
between the two products.
It is possible to increase the combined production of both commodities by having Jane increase her
production of sweaters and Peter increase his production of suits.
The third column gives an example in which Peter specializes fully in suits production
and Jane spends 25 per cent of her time on suits and 75 per cent on sweaters.
Total production of sweaters rises from 250 to 300, while total production of suits goes
from 44 to 52.
Comparative advantage
• This example is only an illustration. The principles can be generalized in the
following way.
 Absolute efficiencies are not necessary for there to be gains from specialization.
 Gains from specialization occur whenever there are differences in the margin of
advantage one producer enjoys over another in various lines of production.
• Total production can always be increased when each producer becomes
more specialized in the production of the commodity in which it has a
comparative advantage.
ROLE OF GOVERNMENT
 Governments play an important part in modern mixed economies.
 They create and enforce important background institutions such as
private property.
 They intervene to increase economic efficiency by correcting
situations where markets do not effectively perform their coordinating functions.
 They also redistribute income and wealth in the interests of equity.
Economic data
 Economists seek to explain observations made of the real
world.
 Real-world observations are also needed to test the
predictions of economic theories.
Index Numbers
 Once data are collected they can be displayed in various
ways.
 Where we are interested in relative movements rather than
absolute ones, the data can be expressed in index numbers.
 Comparisons of relative changes can be made by expressing
each price series as a set of index numbers.
 To do this we take the price at some point of time as the
base to which prices in other periods will be compared.
 We call this the base period.
 The formula of any index number is:
Value of index in period t = (value in period t/value in
base period) × 100
Index numbers – An example
Price of cocoa and coffee
(average price in each quarter; US cents per kg)
Period
Cocoa
Coffee
2001 (Q1)
100.4
146.7
2001 (Q2)
104.5
146.4
2001 (Q3
100.8
129.7
2001 (Q4)
121.8
126.4
2002 (Q4)
149.0
136.6
Calculation of an index of coffee prices
Period
Coffee
Coffee Index
2001 (Q1)
(146.7/146.7)x100
100
2001 (Q2)
(146.4/146.7)x100
99.8
2001 (Q3
(129.7/146.7)x100
88.4
2001 (Q4)
(126.4/146.7)x100
86.2
2002 (Q4)
(136.6/146.7)x100
93.1
Index of cocoa and coffee prices
Period
Cocoa Index
Coffee Index
2001 (Q1)
100
100
2001 (Q2)
104.1
99.8
2001 (Q3
100.4
88.4
2001 (Q4)
121.3
86.2
2002 (Q4)
148.4
93.1
Index numbers as averages
 Index numbers are particularly useful if we wish to combine
several different series into some average. This can be done
by:
 An un-weighted index
 An output-weighted index
Note!
An index that averages changes in several series is the
weighted average of the indexes for the separate series,
the weights reflecting the relative importance of each
series.
Price indexes
 Economists make frequent use of indexes of the price level
that cover a broad group of prices across the whole economy.
 One of the most important of these is the retail price index,
RPI, which covers goods and services that individuals buy.
• All price indexes are calculated using the same procedure.
• First, the relevant prices are collected. Then a base year is
chosen. Then each price series is converted into index
numbers.
• Finally, the index numbers are combined to create a weighted
average index series where the weights indicate the relative
importance of each price series.
Index of cocoa and coffee prices
Period
Equal weights
Coffee = 0.9;
Cocoa = 0.1
2001 (Q1)
100
100
2001 (Q2)
101.9
100.2
2001 (Q3
94.2
89.6
2001 (Q4)
103.7
89.7
2002 (Q4)
120.7
98.6
Price Index
 Consumer Price Index
 Wholesale Price Index
Index of Industrial Production (IIP)
 It is a composite indicator that measures the short term
changes in the volume of production of basket of industrial
products during a given period with respect to that in a
chosen base period.
 It covers 682 items covering 620 items in manufacturing, 61
from mining & quarrying and 1 from electricity sector having
Weightage of 75.53 %, 14.16 and 10.32 % respectively in all
India IIP.
Graphing economic data
 A single economic variable such as unemployment or GDP
can come in two basic forms:
 Cross-section
 Time-series
Graphing economic relationships
 Theories are built on assumptions about relationships
between variables.
 How can such relationships be expressed?
 When one variable is related to another in such a way that to
every value of one variable there is only one possible value of
the second variable, we say that the second variable is a
function of the first.
 When we write this relationship down, we are expressing a
functional relationship between the two variables.
Note!
 A functional relationship can be expressed in words, in a
numerical schedule, in an equation, or in a graph.
Annual Income
Consumption
Reference letter
0
800
p
2,500
2,800
q
5,000
4,800
r
7,500
6,800
s
10,000
8,800
t
Functions
 Let us look in a little more detail at the algebraic expression
of this relationship between income and consumption
spending.
 To state the expression in general form, detached from the
specific numerical example shown previously, we use a
symbol to express the dependence of one variable on
another.
 Using ‘f’ for this purpose, we write C = f(Y).
 This is read ‘C is a function ofY’. Spelling this out more fully, it
reads ‘The amount of consumption spending depends upon
the household’s income.’
 The variable on the left-hand side is the dependent variable,
since its value depends on the value of the variable on the
right-hand side.
 The variable on the right-hand side is the independent
variable, since it can take on any value.
Graphing relationships
 Different functional forms have different graphs - When
income goes up consumption goes up.
 In such a relationship the two variables are positively related to
each other.
The slope of a straight line
 Slopes are important in economics.
 They show you how fast one variable is changing as the other
changes.
 The slope is defined as the amount of change in the variable
measured on the vertical or y-axis per unit change in the
variable measured on the horizontal or x-axis.
Diminishing Marginal Response
Maxima and minima
 So far, all the graphs we have shown have had either a positive
or negative slope over their entire range.
 But many relationships change direction as the independent
variable increases.
Appendices
Corporate Control Mechanisms
 Require managers to hold stipulated amount of firm’s equity
 Increase percentage of outsiders serving on board of directors
 Finance corporate investments with debt instead of equity
Price-Takers vs. Price-Setters
 Price-taking firm
 Cannot set price of its product
 Price is determined strictly by market forces of demand &
supply
 Price-setting firm
 Can set price of its product
 Has a degree of market power, which is ability to raise price
without losing all sales
What is a Market?
 A market is any arrangement through which buyers & sellers
exchange goods & services
 Markets reduce transaction costs
 Costs of making a transaction other than the price of the good
or service
Perfect Competition
 Large number of relatively small firms
 Undifferentiated product
 No barriers to entry
1-86
Monopoly
 Single firm
 Produces product with no close substitutes
 Protected by a barrier to entry
1-87
Monopolistic Competition
 Large number of relatively small firms
 Differentiated products
 No barriers to entry
1-88
Oligopoly
 Few firms produce all or most of market output
 Profits are interdependent
 Actions by any one firm will affect sales & profits of the other
firms
1-89
Globalization of Markets
 Economic integration of markets located in nations around
the world
 Provides opportunity to sell more goods & services to foreign
buyers
 Presents threat of increased competition from foreign
producers
1-90