Basics of Microeconomics | Indian Economy for UPSC CSE PDF Download

To begin with, we first need to chart out the difference between Macro and Micro economic analysis. So, lets begin by looking at the questions that are inquired into for a Macroeconomic analysis.

Questions asked during a Macroeconomic Analysis

• How are prices as a whole influenced in an economy?
• Is the employment situation on the whole getting better or worse?
• What are the reasonable indicators to measure the overall health of the economy?
• What steps should be taken to improve the economy? (Policy imperatives)
• To give you an idea of how Microeconomics analysis is qualitatively different from the above mentioned questions, lets take a brief look at the path of enquiry followed in Microeconomics.

Questions asked during a Microeconomics Analysis 

(i) How price of a particular good or service is influenced? (Not price as a whole, but one or a group of commodities)
(ii) Which factors determine the price of factors of production [land, labour, capital etc.]?
(iii) Which factors influence the productivity of a single or a group of firms? [Not productivity of the entire economy]

• In Macroeconomics, the focus of attention is on the entire economy, which is constituted by various economic agents.
• Economic Agents - Individuals or institutions that take economic decisions.
  Example: a consumer, a firm, an economic sector [coal, steel etc] etc.
• In Microeconomics, the attention is focused more on economic agents, and not the entire system which is constituted by these economic agents.

So now that you know the basic difference between Macro and Micro, lets begin with the “Basics of Microeconomics”

Important Concepts one needs to be familiar with

• The allocation of scarce resources and the distribution of final goods and services are the central problems of any economy.
• To be honest, that's the problem we all face at various points in our lives.
• Your parents, for so long, while budgeting the expenses of your household, have faced this problem of “limited resources, unlimited demands”.
• A successful household budgeting exercise is the one that satisfies maximum possible wants, from limited resources.
• Economy as a field of enquiry or an academic subject starts when one wants to satisfy their desires within the constraint of limited resources.
• Therefore, economy involves the efficient allocation of scarce resources and the distribution of final goods and services to yield maximum possible satisfaction.
• Now, everyone has a limited set of resources, and there are various possible combinations of goods and services that can be created out this limited set of resources. It is the job of an economist to choose the best possible combination that yields maximum satisfaction or that has the maximum utility.
• To understand the above point, lets take a look at the concept of “Production Possibility Set”.

Production Possibility Set

• The collection of all possible combinations of goods and services that can be produced from a given amount of resources and a given stock of technological know how is called a Production Possibility Set.
• Suppose a producer has 100 Kgs of wood and has a good number of wood craftsmen at its disposal.
• Therefore, with this resource of 100 Kgs of wood, the producer can produce following things:
  (i) 10 tables
  (ii) 10 chairs
  (iii) 5 tables + 5 chairs
  And so on…….[assuming 1 table or chair requires 10 kg of wood]
• Now all these options available to the producer forms a “Production Possibility Set”.
• Thus, for the producer, there is always a cost of having a little more of one good [table or a chair] in terms of the amount of other good that has to be foregone. This is cost is known as the “Opportunity Cost” [ we will further elaborate on the concept of opportunity cost in the later part of this chapter]

• So like the producer in the above mentioned example, the entire economy of a country too has a certain “Production Possibility Set”, because every country has a limited set of resources.

• Therefore, it is the job of the policymakers to create appropriate conditions for the choice of the best possible combinations.

• Policymakers solve this problem by choosing one of the two approaches to economic planning:
  (i) Central Planned Economy — In such a system, the government takes all the major decisions like, what goods should be produced, how to distribute those goods, how to produce those goods etc.
  (ii) Market Economy — In such a system, it is not the government but private businesses and rational consumers that through the forces of market, have an influence over major economic decisions.

• Though currently, no government follows either approach in its pure form. Every economy has certain areas that are market driven and certain areas that are controlled by the government. The only difference between countries is that of degrees. In some countries market forces are dominant and the government as a limited role, while there are countries have charted out a dominant role for the government within their economy.

How does a Market Economy work?

Price determination

• So, at Market Equilibrium, 6 million quantity of goods shall be supplied at $3000.
• This equilibrium shall yield maximum satisfaction as only that much amount is produced that people demanded, unlike in a government controlled economy, where supply is entirely regulated by the government.
• The advantage of following a market economy approach is that it is the best possible way of achieving “Economic efficiency”.
• Economic Efficiency - It implies the use of production process or resource combination which ensures minimization of cost incurred on using resources to produce a given level of output.
• 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.
• It is the invisible hand of the market that ensures that only that much amount of goods or services are supplied, that is demanded. 

Demand Side Analysis of Economy

• Law of Demand - Conditional on all else being equal, as the price of a good increases, quantity demanded decreases; and conversely, as the price of a good decreases, quantity demanded decreases. [Assumption - Consumer is rational]
• Therefore, the law of demand describes an inverse relation between demand and price.
  

Though there are some exceptions to this law of demand. These exceptions are as following

• Veblen Goods - These are types of luxury goods for with quantity demanded increases as the price increases, an apparent contradiction of the law of demand. A higher price of may make a product desirable as a status symbol in the practice of conspicuous consumption.
  Example - Luxury cars, Luxury paintings, Swiss watches, expensive wines and spirits, luxury handbags etc. Chances are that a Veblen good is a positional good [possession of which determines high status in society] too.
• Giffen Good or Giffen Paradox - It is a low income, non-luxury, inferior good, that defies the consumer demand theory. Its demand is directly proportional to its price. Generally, inferior goods with very few close substitutes show “Giffen Paradox”.
  Example - Giffen Goods include inferior staple goods like rice, wheat etc. Giffen paradox is so rare that some economists doubt its existence and call it a phenomenon that exists in theory only.

Some other types of goods

• Normal Goods - A good whose quantity demanded is directly proportional to the income of the consumer.
• Inferior Good - A good whose demand moves in the opposite direction of the income of the consumer.
  Example - inferior quality rice, low grade food items etc. When a consumer becomes rich, he/she stops consuming inferior goods and thus their demand falls.
• Complimentary Goods - A good whose use is related to the use of an associated or paired good. Two goods [A and B] are complimentary if using more of good A requires the use of more of good B.
  Example - Printer & Ink Cartridge, Car & Petrol, Pencil and Eraser etc. If price of one compliment increases, the demand for the other component decreases. [and vice versa].
• Substitute Goods - A substitute is that good which can be used to replace another good for a similar purpose. Goods A and B are substitutes if they both can be used interchangeably for an almost identical purpose.
  Example - Pepsi & Coke, McDonalds & Burger King, Tata Tea & Red Label Tea etc. If price of a substitute increases, the demand for the other substitute increases [and vice versa]

Price Elasticity of Demand

• Price elasticity of demand or elasticity, is the degree to which the effective demand for something changes as its price changes.
• It actually measures the responsiveness of consumers to a change in a product’s price.
• The formula for calculation of price elasticity of demand is the percentage change in the quantity demanded divided by the percentage change in the price.

E_p = Percentage change in quantity demanded/Percentage change in Price
E_p > 1, elastic

E_p < 1, Inelastic
E_p = 1, Unit Elastic

• Demand for a necessary good is generally price inelastic, while demand for a luxury good is price elastic.
• Elasticity is also influenced by the availability of substitutes. If close substitutes are available, then that particular good will be highly elastic.

Production Function/Supply Side

• In economics, a production function gives the technological relation between quantities of physical inputs and quantities of output of goods.
• So, let’s suppose there are two inputs used by a producer to produce a given quantity of goods.
• Inputs = Labour (L) & Capital(K)
• Output is denoted by Q
• So a production function would look like this: Q = f (L,K) 

Generally, each production unit uses 4 types of inputs, which are also known as Factors of Production:

• Land
• Labour
• Capital
• Entrepreneurship

A producer does not get these Factors of Production for free, they come at a price: 

• For Land he pays Rent
• For Labour he pays wages 
• For Capital, interest is paid
• For Entrepreneurship, profit is paid.

Rent, Wages, Interest and Profit are therefore known as Factor Prices or Factor Incomes. 

While talking about the above mentioned Production Function, we have taken following assumptions: 

• Efficient use of all inputs [inputs are utilised at their full efficiency], and
• A Production Function is defined for a given technological level.

What is an Isoquant? 

• An Isoquant is a set of all possible combinations of two inputs [labour & capital] that yield the same level of output.
• The Isoquant curve is a graph, used in the study of Microeconomics, that charts all inputs that produce a specific level of output.
• So, one Isoquant represents all possible combinations of labour and capital, that will yield similar output.
• This graph is used as a metric for the influence that the inputs have on the level of output or production that can be obtained.
•  The Isoquant curve assists firms in making adjustments to inputs to maximize outputs, and thus profits.

Some important properties of Isoquant curve are as following:

• The curve is generally downward or negative sloping
• The curve is generally convex to the origin
• Isoquant curves cannot intersect or be tangent to one another
• The higher or outer the curve, the higher is the output. For example, in the above diagram, IQ₃ has the highest output, then IQ₂ and IQ₁ has the lowest output.
• Isoquant curves cannot touch either of the axes (X or Y)

Total, Average and Marginal Product: 

• As we all know that in a production process we need a particular proportion of inputs to get a specific output.
• For a firm, these inputs are the factors of production [land, labour, capital and entrepreneurship].
• To know the contribution of a particular input, we keep all the other inputs constant and vary that particular input to reveal the relation of that input with the output.
• So, if we want to know the relation of labour with the total output of a firm, we make use of Total, Average and Marginal Product of Labour. 
• Total Product = Total return on a variable input
• Average Product = Output per unit variable input [ Total Product / Total units of variable input]
• Marginal Product = It is defined as the change in output per unit change in variable input [change in total product / change in variable input].
• Law of Diminishing Marginal Product - It says that if we keep increasing the employment of an input, with other inputs fixed, eventually after a point, Marginal Product of that input will start to decline.
• Law of Variable Proportions - This law states that if we keep one factor input variable and others constant, the marginal product curve of that input will follow an inverted ‘U’ shape.

Return to Scale 

• Constant Return to Scale: A production function under which, a proportional increase in all inputs results in an increase in the output by the same proportion.
  Example - Eg - 2Q = f (2L, 2K)
• Increased Return to Scale: A production function under which, a proportional increase in all the inputs results in an increase in output by a proportion greater than that with which the inputs were increased.
  Example - 10Q = f (8L, 8K)
• Decreased Return to Scale: A production function under which, a proportional increase in all the inputs results in an increase in output by a proportion less than that with which the inputs were increased.
  Example - 3Q = F(8L, 8K).

Concept of Cost of Production:

• Average Cost of Production = Total cost of production / Total Number of units produced
• Marginal Cost of Production = Change in Total Cost / Change in total units produced
• Fixed Cost / Overhead Cost - These are costs which are incurred in hiring fixed factors of production whose amount cannot be altered in the short run. For example costs incurred in setting up of production plant or cost of buying machinery.
• Variable Cost / Prime Cost / Direct Cost - These are costs incurred on employment of variable factors of production whose amount can be altered in the short run. For example, costs incurred on labour, raw material etc.
• Total Cost = Total Fixed Cost + Total Variable Cost

Opportunity, Accounting and Economic Cost:

• Opportunity cost - Opportunity or Alternative cost of making a particular choice is the value of the most valuable choice out of those that were not taken. It is the cost incurred by not enjoying the benefit associated with the next best alternative choice.
• Accounting Cost - These are the explicit costs incurred in a choice that one has chosen.
• Economic Cost = Opportunity Cost + Accounting Cost

Economic Cost = 20 + 10 = 30 

Market Structure

The structure of markets can be basically differentiated on the basis of two major features

• Number of buyers and sellers in the market
• Is the product being sold in the market Homogeneous or Differentiated?

Homogeneous Products - It is a product that cannot be distinguished from competing products from different suppliers. In other words, the product has essentially same physical characteristics and quality as similar products from other suppliers. One product can be easily substituted for the other.
Differentiated Product - Product differentiation is the process of distinguishing a product or a service from other computing products or services. Thus, differentiated products are those that can be distinguished from competing products by other suppliers.
Example - Taj tea and TATA tea.

Different Types of Market Structures are as following
1. Perfect Competition

• Under this form of market structure, there are a large number of producers as well as buyers.
• The products that are being sold in such a market are homogeneous.
• There are no entry or exit barriers for firms. That means free entry and exit for firms.
• The demand in such a market is ‘perfectly elastic’ i.e. infinitely elastic.
• Both consumers and producers are price takers, and the producers have zero control over price and quantity of production.

2. Monopolistic Competition

• Large number of buyers and sellers
• Unlike perfect competition, the products here are differentiated.
• Because of Product Differentiation, the producers have some form of monopoly and control over price of their product [though very little control, but more than perfect competition].
• All products by different sellers in the market are close substitutes of each other.

3. Oligopoly

• Under this form of market structure, there are very few number of big producers who control the market.
• Each producer has a large market share.
• On the basis of product differentiation, Oligopoly can be further subdivided into 2 parts:
  Pure Oligopoly = When products are homogeneous
  Differentiated Oligopoly = When products are differentiated

4. Monopoly 

• One producer with complete control over market share.
• Single unique product with no close substitutes.
• This market structure is the complete polar opposite of perfect competition.
• Here, the producer has complete control over price and production levels.

Concept of Economy of Scale

It is the cost advantage that enterprises obtain due to their scale of operation, with cost per unit of output declining with increasing scale of production.

Therefore, the concept of economy of scale states that as a production unit gets bigger, its average cost comes down and that unit becomes more efficient.