Short Notes: Introduction to Microeconomics

Concept of Microeconomics

Orientation to the subject matter tells us that:

Microeconomics is the study of economic problems (or economic issues) at the level of an individual ? individual consumer (also called household) or individual producer owning a firm or an industry.

As a consumer/household, your means (or resources) are scarce in relation to your wants. The problem is to allocate your limited resources to the purchase of alternative goods in a manner that gives you maximum satisfaction.

As a producer again, your resources are scarce in relation to goods you would like to produce. Accordingly the problem: the problem of allocation of limited resources to the production of alternative goods, in a manner that generates maximum profits.

Resource allocation is the central issue in microeconomics, whether we are studying it from the viewpoint of a consumer or a producer. However, generally, when we talk of resource allocation we refer to it from the viewpoint of producers. Thus, resource allocation by the producers is the centrestage of microeconomics. Studying microeconomics means studying the problem of resource allocation by the producers in an economy.
Economy: It refers to a system by which people of an area (or a country) earn their living. If most people of a country earn their living largely by allocating their resources to the production of agricultural goods, economy of that country would be called ‘agricultural economy’ . Likewise, a country may have an industrial economy if people of that country earn their living largely by allocating their resources to the production of industrial goods.

Problem of Resource Allocation

Allocation of resources is a problem. Why? Answer is simple:

(i) Resources are scarce in relation to the goods we wish to produce for the satisfaction of our wants.

(ii) Resources have alternative uses.

Stop! Pause! Think!

Scarcity alone is not enough to cause the problem of resource allocation. The problem (of resource allocation) would not exist if resources were simply scarce, and did not have alternative uses. Think of a situation when you have a piece of land (it is fixed for you, and therefore scarce). But this piece of land can be used only for the production of rice. What do you do in such a situation? You simply produce rice and relax; where is the problem?

The problem arises because land has alternative uses: you may grow on it rice, wheat, cotton or sugarcane. But you cannot grow all crops because land is fixed / scarce. Hence, the problem of choice: you are to choose which crop is to be grown and how much. Thus, the problem of resource allocation is essentially the problem of choice: choosing across different possibilities of production with your limited resources.

Problem of Resource Allocation is essentially the Problem of Choice

Given you limited resources and the fact that resources have alternative uses, you cannot escape the problem of choice. You are to choose what commodities are be produced, for whom are these to be produced and how are these to be produced. Choice relating to ?what to produce? is important essentially because everything cannot be produced with the limited resources. ?For whom to produce? is important because an individual, producer cannot produce for everybody in the economy. How to produce is important, because scarce resources command price and therefore, need to be optimally used. (Optimum use of a resource means using a resource in a manner such that the unit cost of production is minimised.) Problem of choice indeed is the essence of economic problem, and the core content of microeconomics.

Central Problems of an Economy

We now know that the problem of resource allocation is the essence of economic problem, and the core content of microeconomics. We have also known that the problem of resource allocation is essentially the problem of choice, having three aspects:

(i) What to produce,

(ii) How to produce,

(iii) For whom to produce.

Together, these are called central problems of an economy.

Central Problems of An Economy

These are:
(i) What to produce,
(ii) How to produce,
(iii) For whom to produce.
These are three related aspects of the problem of resource allocation. These are called central problems of an economy because no economy in the world can escape them. Every economy has to face them, because scarcity and the problem of choice is a universal fact.

What to Produce

Because resources are scarce, you are to decide what goods are to be produced and in what quantity. More of Good-X means less of Good-Y, other things remaining constant.

How to Produce

You are to simultaneously decide how to produce goods. Factors of production are scarce. Land, labour, capital and entrepreneurship (the four factors) may not be available in the ratio you desire. Hence, the problem of choice regarding the ratio in which factors are to be used. This is also called the problem of choice of technique.

For Whom to Produce

Also, you are to simultaneously decide the type of buyers/consumers you are targeting at. More goods for the rich buyers means less for the poor. Implying unequal distribution. Social justice is denied. But, certainly profits are high if your buyers are rich. High profits are essential for further investment.

Production Possibility Curve (PPC)

PPC (Production Possibility Curve): A Tool we need for further Analysis

Analysis of the problem of Resource Allocation (or the Central Problems of an Economy) becomes easy if we know the concept of PPC.

What is PPC?

It is a curve showing different possibilities of production (of a set of two goods), given resources and technology. Check the following table:

Combination Good-A(Watches) Good-B(Shirts)
A 500 0
B 450 100
C 390 200
D 320 300
E 220 400
F 100 500
G 0 500

 

Draw a graph, using this table. You get PPC, as under:

Marginal Opportunity Cost

Marginal opportunity cost is the ratio between loss of output of Good-A and gain of output of Good-B when some resources are shifted from Good-A to Good-B

Thus, marginal opportunity cost is the loss of output of Good-A for a unit gain of output of Good-B when some resources are shifted from Good-A to Good-B.

  • From A to B, marginal opportunity cost = 0.5
  • Similarly, from B to C, marginal opportunity cost = 0.6
  • And, from C to D, marginal opportunity cost =0.7
  • Marginal opportunity cost from D to E = 1
  • From E to F, marginal opportunity cost = 1.2
  • Finally, from F to G, marginal opportunity cost = 2
  • Marginal opportunity cost tends to increase as resources continuously shift from Good-A to Good-B.

Why? Because resources are allocated to their specialised usage. If their usage is disturbed, loss of output (per unit of the gain of output) tends to increase.

It is because marginal opportunity cost tends to increase (as resources are shifted from Good-A to Good-B), PPC becomes concave to the origin.

 

PPC is always Concave
Because marginal opportunity cost of shifting resources from Good-A to Good-B tends to rise.
Significance of PPC

PPC helps us to analyse the problem of resource allocation. Let us refer to PPC again, as in Fig. 2.

Loss of output of Good-A = FG

Gain of output of Good-B = AB

Marginal Opportunity Cost = 

We want another shift, from Q1 to Q2

Now,

Loss of output of Good-A = GH

Gain of output of Good-B = BC

Marginal Opportunity Cost = 

Note carefully:

GH > FG (evidently)

AB = BC (deliberately shown to be equal)

Thus, problem of allocation (or of reallocation of resources) is a serious problem because:

as resources shift from Use-1 to Use-2, marginal opportunity cost tends to rise.

Now, you may ask: why should we shift resources from Use-1 to Use-2? Why not stick to existing allocation? Here comes your economics. Shifting resources from one use to the other is like shifting from one business to the other. Why do you do it? Obviously because you find there is a shift in the structure of demand. After all production is for sale in the market. Structure of production must change in accordance with change in the structure of demand. When you face the problem of resource allocation, you face the problem of choice. It is the basic economic problem. It arises primarily because resources are scarce (and they have alternative uses) and because our wants are diverse and unlimited. All this is microeconomics.

Resources are Scarce, but their Availability may increase Over Time

Scarcity is a universal phenomenon. But in a country or to an individual in a country, availability of resources may increase over time. In terms of PPC, it implies a shift to the right, as in Fig. 3.

Technology may Improve Over Time

Technique of production tends to improve over time. Improvement of technology implies a situation of greater output with the same resources Figs. 4, 5 and 6 illustrate different situations of improvement in technology.

Basic Assumptions of PPC

PPC is drawn on two basic assumptions:

(i) Technology is constant,

(ii) Given resources are fully as well efficiently utilized.

PPC when given resources are not fully utilized or are underutilized:

PPC when given resources are not efficiently utilized:

You are on ab, while you can be on cd with the available resources and technology.

Alternative Approach to the Concept of Opportunity Cost

Resources are scarce, all right. But they have alternative uses as well. For example, we can use land to produce wheat, rice or sugarcane. Likewise, labour can be utilized in industry A (producing cloth) or in industry B (producing shoes). Thus, you may be offered a job in industry A, as well as in industry B. So, industry A and industry B are offering 2 different opportunities. You are to forego one in favour of the other. Other things remaining constant, you will forego that opportunity where the salary is less. Or, you will avail that opportunity where your value (in terms of your salary) is more. Now, note the following:

  • You are availing the best opportunity.
  • You are foregoining the next-best opportunity.
  • Your opportunity cost is what you forego. It is your value in the next best opportunity.

Concept of Economy

The term ‘economy’ in economics refers to a system by which people of an area earn their living. Example : Indian economy is largely an agricultural economy because most people in the country earn their living through agriculture.

Concept of Price Mechanism

Price mechanism refers to market mechanism in which the forces of supply and demand operate free of any government interference.

Role of Price Mechanism.

It helps to solve the central problems in a capitalist economy. This is how it happens:

(i) What to Produce and Price Mechanism

Price mechanism shows relative prices of goods and services in the market, as determined by the forces of supply and demand. On the basis of this knowledge, producers will decide to produce those goods which will offer them maximum profit.

(ii) How to Produce and Price Mechanism

It is a problem of choice of technique: (i) labour intensive technique or (ii) capital intensive technique (Labour intensive technique uses more labour per unit of capital. Capital intensive technique uses more capital per unit of labour). Price mechanism will offer signals to the producers on the cost of different factors of production with a view to maximising profits, they will choose that technique which minimises their cost of production.

(iii) For Whom to Produce and Price Mechanism

Price mechanism offers signals to the producers on the prospective buyers of the commodity. A producer will prefer to produce for those buyers who will buy goods at high prices or who have income/resources to buy the goods. This is because producers tend to maximise their profits.

Types of Economies

(i) Capitalist Economy

It is a free economy in which producers take the decisions regarding what to produce, how to produce and for whom to produce freely on the basis of market situations. Maximisation of profit is the principle objective of the producers. Price mechanism is the principle economic instrument that helps to solve the central problems.

(ii) Socialist Economy

It is centrally planned economy. The central authority of the government takes the decisions regarding what, how and for whom to produce. Maximisation of the social welfare is the principle objective.

(iii) Mixed Economy

It is an economy showing features of a capitalist economy as well as socialist economy. Price mechanism is the principle economic instrument. But the government controls and regulates it. Maximisation of profit is allowed, but not at the cost of social welfare.

Note : In a socialist economy (and to some extent in a mixed economy) price mechanism does not operate free of control by the government. Accordingly, the central authority of the government decides what goods to produce, how to produce those goods and for whom to produce those goods. The government is particularly concerned with ‘Aam Admi’ (common man). It ensures that common man gets essentials of life at the minimum possible price. Accordingly, a solution to the central problems giving priority to social welfare rather than profit maximisation.

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