Micro Economics

Introduction
 Economics
• The application of economic theory and the
tools of decision science to examine how an
organization can achieve its aims or objectives
most efficiently.
– applications of economic theory
– quantitative methods
– statistical methods
– computational methods
What is the ‘Economic Problem’?
The ECONOMIC PROBLEM is the problem of
allocating resources efficiently
 to achieve objectives
 while satisfying constraints, such as
 scarcity
 requirement

 feasibility
 Economic Analysis are important to a
variety of public and private sector
activities. For e.g.
1. analysing costs and benefits of a project, or a
scheme,
2. Pricing strategy of a product
3. user fees (price) for public parks, water, toll road,
4. designing scholarship program,
5. causes of unemployment, inflation,
6. tax rate from revenue and equity point
 Economic Analysis are important to a
variety of public and private sector
activities. For e.g.
1. analysing costs and benefits of a project, or a
scheme,
2. Pricing strategy of a product
3. user fees (price) for public parks, water, toll road,
4. designing scholarship program,
5. causes of unemployment, inflation,
6. tax rate from revenue and equity point
 Microeconomics
• The study of the behaviour of individual entities in a
market economy
– Consumers
– Firms
• Real estate
• Banking
• FMCG
– Markets
– Market failures
Caselet: Is the Private Doctor’s Office going to disappear
(Related)
https://www.ted.com/talks/david_autor_why_are_there_still
_so_many_jobs
 Positive versus Normative Analysis

• Divya: Minimum wage laws cause

unemployment
• Tara: The government should raise the
minimum wage

Positive statements are descriptive

Normative statements are prescriptive
 Principles of Microeconomics

• Principles of Individual Choice

• Principles of Individual Interaction

Principles for Individual Choice
 1. Tradeoffs
Decision making is a process of making optimal tradeoffs
because resources are scarce
Cost versus quality
Employee versus customer
Etc.
How to make the optimal tradeoff?

“There is no free lunch.”

2. Optimal tradeoff: Decision at the Margin

Most decisions not all or nothing

Should I watch the second half of the Uruguay Italy game or
should I study?
Should Apple ship out 300,000 more ipods?
‘Marginal’ means incremental, or additional
Marginal benefit - individual
Marginal revenue - firm
Marginal cost
So optimal tradeoff involves equalizing marginal
benefit/revenue and marginal cost
4. Entities respond to incentives

Cars at a toll bridge

Assumption of ‘rationality’

Behavioural economics
Role of ethics
Principles for Interaction
between Individuals
Interaction Changes Things

Economies consist of individuals,

firms, families, countries, that
interact with each other
Interaction makes things interesting
 5. Gains from trade
Case 1: Boss better than secretary at decision
making, secretary better at typing, boss
focuses on decision making alone and lets
secretary focus on typing alone

Case 2: Boss better than secretary at both

typing and decision making but ‘more better’
in decision making, so focuses on decision
making alone and lets secretary focus on
typing alone
6. Markets organize economic
activity
MARKETS AS A DEVICE TO RESOLVE THE THREE
BIG
questions
MARKETS AS MECHANISM FOR COORDINATING
AND
RECONCILING INDIVIDUAL CHOICES IN A MANNER
THAT
PROVIDES ANSWERS TO THE THREE SOCIAL
DECISIONS
 7. Government intervention is sometimes
necessary
• Markets can lead to efficient outcomes, but there are
collective action failures
– Blood donation
– Traffic
– Price wars
• Markets need not lead to equity
• Markets can fail on account of externalities
– Smoking
– Vaccinations
 Trade-offs: The Production Possibility Frontier
(PPF)
•The production possibility frontier (PPF)
illustrates the trade-offs facing an economy that
produces only two goods. It shows the
maximum quantity of one good that can be
produced for any given production of the other.

•The PPF improves our understanding of trade-

offs by considering a simplified economy that
produces only two goods by showing this trade-
off graphically. 19
 Production Possibility frontier
• PPF -The locus of points that shows the
combinations of two or more goods that can
be produced at the their maximum level with
a given amount of resources.
• Productive efficiency on PPF – cannot increase
one product without reducing the other
• Unutilized resources indicate inefficiency and
deviation away from PPF.
Tom’s Trade-offs: The Production Possibility Frontier

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Increasing Opportunity Cost

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Economic growth results in an outward shift of the PPF
because production possibilities are expanded.

Production is initially at point A

(20 fish and 25 coconuts),  it
can move to point E (25 fish and
30 coconuts).
The economy can now produce
more of everything.

Economic Growth

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Comparative Advantage and Gains from Trade
Ex.: Tom and Hank24
Comparative Advantage and Gains from Trade
Ex.: Tom and Hank 25
 Tom’s Hank’s
Opportunity Opportunity
Cost Cost

One
3/4 coconut 2 coconuts
fish

One
4/3 fish 1/2 fish
coconut

Tom and Hank’s Opportunity Costs of Fish and

Coconuts
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 Specialize and Trade

•Both are better off when they each specialize in

what they are good at and trade.
•It’s a good idea for Tom to catch the fish for both
of them, because his opportunity cost of a fish in
terms of coconuts not gathered is only 3⁄4 of a
coconut, versus 2 coconuts for Hank.
•Correspondingly, it’s a good idea for Hank to
gather coconuts for the both of them.
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Comparative Advantage and Gains from Trade
Ex.: Tom and Hank

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Comparative Advantage and Gains from Trade
Ex.: Tom and Hank

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 How Gain from Trade arises

Both Tom and Hank experience gains from trade:

 Tom’s consumption of fish increases by two, and his
consumption of coconuts increases by one.
 Hank’s consumption of fish increases by four, and his
consumption of coconuts increases by two.30
 Comparative vs. Absolute Advantage

•An individual has a comparative advantage in producing a good

or service if the opportunity cost of producing the good is lower
for that individual than for other people.

•An individual has an absolute advantage in an activity if he or

she can do it better than other people. Having an absolute
advantage is not the same thing as having a comparative
advantage.

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Tom vs. Hank—Absolute vs. Comparative
•Tom has an absolute advantage in both activities: he can
produce more output with a given amount of input (in this
case, his time) than Hank.
•But we’ve just seen that Tom can indeed benefit from a deal
with Hank because comparative, not absolute, advantage is
the basis for mutual gain.
•So Hank, despite his absolute disadvantage, even in coconuts,
has a comparative advantage in coconut gathering.
•Meanwhile Tom, who can use his time better by catching fish,
has a comparative disadvantage in coconut-gathering.

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Comparative Advantage and International
Trade

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Comparative Advantage and International Trade………..

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 Comparative Advantage and International Trade

•Just like the example of Tom and Hank, the U.S. and Canada can
both achieve mutual gains from trade.
•
•If the U.S. concentrates on producing pork and ships some of its
output to Canada, while Canada concentrates on aircraft and
ships some of its output to the U.S., both countries can consume
more than if they insisted on being self-sufficient.

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PITFALLS: Misunderstanding Comparative Advantage

A common mistake is to confuse comparative advantage with

absolute advantage.
Ex.: U.S. vs. Japan in 1980s
Commentators: “U.S. might soon have no
comparative advantage in anything”
Wrong! They meant “absolute advantage”

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 Circular-Flow of Economic Activities

•A household is a person or a group of people that share their income.

•A firm is an organization that produces goods and services for sale.

•Firms sell goods and services that they produce to households in

markets for goods and services.

•Firms buy the resources they need to produce—factors of production

—in factor markets.

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