ECONOMY - BASIC OF MIROECONOMICS

Basics of Microeconomics
The allocation of scarce resources and the distribution of the final goods and services are the central
problems of any economy.
The collection of all possible combinations of the goods and services that can be produced from a given
amount of resources and a given stock of technological knowledge is called the production possibility set
of the economy.
Thus, there is always a cost of having a little more of one good in terms of the amount of the other good
that has to be forgone. This is known as the opportunity cost of an additional unit of the goods.
These basic problems are generally solved through two ways
Central planned economy - In such a system, the government takes all the major decisions like what goods
to be produced; how to produce those goods; prices of the produced goods and how to distribute the
economic output in the country.
Market Economy - In such an economy, it is not the government but private businesses and rational
consumers that through the forces of market have an influence over major economic decisions.
Generally all economies are a mixture of two. Difference lies in the degrees of application of each of these
ways.
Positive economic analysis – In this, we try to analyze the different mechanisms and figure out the
outcomes which are likely to result under each of these mechanisms. Thus its value free
Normative economic analysis –In this we evaluate as to how desirable are the mechanisms and their
outcomes.
Generally it is difficult to separate the two into water-tight compartments.
Market Equilibrium

Upward sloping “supply curve” depicts that as the price of a good increases, producers are incentivised to
produce more and hence supply of that good increases.
The point at which these two curves intersect is called “market equilibrium”. This is the point where
demand matches supply.
Adam Smith called it the ‘invisible hand’.
Invisible Hand - the unobservable market forces causing unintended social benefits from self-interested
actions of individuals in a free- market economy.
According to Adam Smith, the invisible hand sin a free market economy will yield maximum satisfaction
because :
▪ It will lead to optimal allocation of scarce resources.
1

▪ It will lead to efficient distribution of goods and services.

Page

Demand

www.chetanbharat.com Call / WhatsApp: 9779353345

 Law of demand - If a consumer’s demand for a good moves in the same direction as the consumer’s
income, the consumer’s demand for that good must be inversely related to the price of the good.
Normal Goods – a good whose quantity is directly proportional to the income .
Inferior goods – a good whose demand moves in the opposite direction of the income of the consumer.
E.g – coarse cereals, low quality food etc
A good can be a normal good for the consumer at some levels of income and an inferior good for her at
other levels of income. At very low levels of income, a consumer’s demand for low quality cereals can
increase with income. But, beyond a level, any increase in income of the consumer is likely to reduce her
consumption of such food items.
Complimentary goods – demand for complimentary goods are inversly related to price.
Substitute goods – demand for Substitute goods is directly related to the price.
Demand Elasticity
Price-elasticity of demand is a measure of the responsiveness of the demand for a good to changes in its
price. Price-elasticity of demand for a good is defined as the percentage change in demand for the good
divided by the percentage change in its price.
If at some price, the percentage change in demand for a good is less than the percentage change in the
price, then |eD|<1 and demand for the good is said to be inelastic at that price. If at some price, the
percentage change in demand for a good is equal to the percentage change in the price, |eD|= 1, and
demand for the good is said to be unitaryelastic at that price. If at some price, the percentage change in
demand for a good is greater than the percentage change in the price, then |eD|>1, and demand for the
good is said to be elastic at that price.
In general, demand for a necessity is likely to be price inelastic while demand for a luxury good is likely to
be price elastic.
The demand for a good is likely to be elastic if close substitutes are easily available. On the other hand, if
close substitutes are not available easily, the demand for a good is likely to be inelastic. E.g – pulses
The relationship between price of the good and the total expenditure to be incurred by the consumer is
dependent upon the elasticity.
Product Function
The production function of a firm is a relationship between inputs used and output produced by the firm.
Production function considers only the efficient use of inputs.
A production function is defined for a given technology. It is the technological knowledge that determines
the maximum levels of output that can be produced using different combinations of inputs.
The inputs that a firm uses in the production process are called factors of production.
An isoquant is the set of all possible combinations of the two inputs that yield the same maximum
possible level of output. Each isoquant represents a particular level of output and is labelled with that
amount of output.
Relationship between the variable input and output, keeping all other inputs constant, is often referred
to as Total Product (TP) of the variable input. Also called total return of a variable input
Average product is defined as the output per unit of variable input.
Marginal product of an input is defined as the change in output per unit of change in the input when all
other inputs are held constant.
So total product is the sum of marginal products. Average product of an input at any level of employment
is the average of all marginal products up to that level. Average and marginal products are often referred
to as average and marginal returns.
Law of diminishing marginal product - The law of diminishing marginal product says that if we keep
increasing the employment of an input, with other inputs fixed, eventually a point will be reached after
2

which the resulting addition to output (i.e., marginal product of that input) will start falling.
Page

Law of variable proportions - It says that the marginal product of a factor input initially rises with its
employment level. But after reaching a certain level of employment, it starts falling. Thus the curve of

www.chetanbharat.com Call / WhatsApp: 9779353345

 marginal product is an inverted ‘U’ and because average product is also dependent upon marginal
product, its curve is also an inverted ‘U’.
Cost of Production
Average Cost = Total Cost of Production / Output
Marginal Cost = Change in Total Cost / Output
Fixed / Overhead Cost - these are the costs which are incurred in hiring fixed factors of production whose
amount cannot be altered in the
short-run. Eg - cost of plant and machinery.
Variable Cost - These are costs incurred on employment of variable factors of production whose amount
can be altered in the short-run. Eg
▪ Labour, raw material etc.
Total Cost = Total Fixed Cost + Total Variable Cost
Opportunity Cost - When an option is chosen from alternatives, the opportunity cost is the "cost" incurred
by not enjoying the benefit associated with the best alternative choice. The New Oxford
American Dictionary defines it as "the loss of potential gain from other alternatives when one alternative
is chosen.
Accounting Cost - these are the explicit costs incurred in conducting a business. For example expenditure
on raw material, labour wages, plant & machinery.
Economic Cost = Opportunity Cost + Accounting Cost.
Economy of Scale - It is the cost advantage that enterprises obtain due to their scale of operation, with
average cost decreasing wit increase in scale of operation.
Market Structures
Perfect Competition -
Large number of producers and consumers
Homogenous product market
Free entry and exit of firms
Monopolistic Competition -
A large number producers
Differentiated product market
Oligopoly - a few number of big producers
Pure Oligopoly (homogeneous products)
Differentiated Oligopoly (Differentiated products)
Monopoly -
A single firm capturing the entire market
Unique product with no close substitutes
3
Page

www.chetanbharat.com Call / WhatsApp: 9779353345

 MCQs
1. Which of the following statements is/are true ?
1. Law of demand holds true for normal goods
2. The demand for a substitute good is inversely proportional to the price of other
substitute.
Select the correct option given below :
a) Only 1
b) Only 2
c) Both 1 and 2
d) Neither 1 nor 2
Ans. (a)
2. Consider the following statements regarding Opportunity Cost ?
1. Opportunity cost is similar to economic cost
2. Opportunity cost is the implicit cost of production
3. Accounting cost is the explicit cost of production
Which of the above statement is/are correct
a) 1 and 2 only
b) 2 and 3 only
c) 1 and 3 only
d) 1, 2 and 3
Ans. (b)
3. Which of the following statement regarding Veblen goods is false ?
a) Veblen phenomenon is associated with conspicuous consumption
b) It is an apparent contradiction to law of demand
c) Sometimes, Veblen goods can show giffen paradox
d) Generally, Positional Goods showcase Veblen phenomenon
Ans. (c)
4. Consider the following statements regarding elasticity of demand :
1. Increase in the price of inelastic goods increases total expenditure on those goods
2. Goods with little or no close substitutes generally show high price elasticity.
Which of the above statements is/are correct ?
a) Only 1
b) Only 2
c) Both 1 and 2
d) Neither 1 nor 2
Ans. (a)
4
Page

www.chetanbharat.com Call / WhatsApp: 9779353345

 5. Consider the following circumstances and predict the market structure that exists in those
circumstances :
1. Homogeneous product
2. Few number of firms
3. Firms large in size
What type of market structure are we talking about ?
a) Perfect competition
b) Monopoly
c) Monopolistic competition
d) Pure Oligopoly
Ans. (d)
5
Page

www.chetanbharat.com Call / WhatsApp: 9779353345