MICROECONOMIC

Meaning of microeconomics
Significance of microeconomics
Methods of microeconomics
Theories and models of
microeconomics
Positive & normative Economics
Basics of Demand & supply
Market Mechanism
Elasticity of Demand & Supply
What is Microeconomics

 Is a branch of economics that studies how

households and firms make decisions to
allocate limited resources
 Microeconomics deals with the behavior of
individual economic units.
Significance of Microeconomics

 The goal is to show how to apply

microeconomic principles to actual
decision making problems.
 Some extra motivation early on never
hurts.
 Microeconomics Theories and
Models
 Theories-are developed to explain observed phenomena in terms
of a set of basic rules and assumption.

 Theory of the firm, for example, begins with a simple assumption-

firms try to maximize their profits. The theory uses to explain how
firm choose the amount of labors, capital, and raw materials that
they use for production and the amount of output they produce.

 Model – is a mathematical representation, based on economic

theory, of a firm a market or some entity. For example a particular
model used by a firm is by how much the firm’s output level will
change as a result of, say 10-percent drop in the price of raw
materials.
 Positive & Normative Economics
 POSITIVE ECONOMICS
 Positive Analysis deals with explanation
and prediction
 It is central to microeconomics
 It is an analysis describing relationship
between cause and effect
  NORMATIVE ECONOMICS
 Normative Analysis examining questions
with what ought to be.
 It is not only concerned with alternative
policy option and it also involves the
design of particular policy choices.
 It is often supplemented by value
judgment.
Market Mechanism
 Market mechanism is a term from economics
referring to the use of money exchanged by
buyers and sellers with an open and understood
system of value and time trade offs to produce
the best distribution of goods and services. The
use of the market mechanism does not imply a
free market; there can be captive or controlled
markets which seek to use supply and demand,
or some other form of charging for scarcity, both
in social situations and in engineering.
Basics of Supply and Demand
 Supply and demand is an economic model
based on price, utility and quantity in a
market.
 The Basics model of supply and demand is
the work horse of macroeconomics.
 It help us understand why and how prices
changes, and what happens when the
government intervenes in the market.
 The supply-demand model combines two
important concepts; the supply & demand
curve. It is important to understand what this
curve represent.
 Demand & Supply Curve

 Demand Curve – is the relationship

between a quantity of a good that
consumers are willing to buy and the
price of the good.
 Supply Curve – relationship between the
quantity of a good that producers are
willing to sell and the price of the good.
  When consumers increase the quantity
demanded at a given price, it is referred
to as an increase in demand.

Demand Curve  Increased demand can be represented on

the graph as the curve being shifted
outward.
 In the diagram, this raises the equilibrium
price from P1 to the higher P2. This
raises the equilibrium quantity from Q1 to
the higher Q2. A movement along the
curve is described as a "change in the
quantity demanded" to distinguish it from
a "change in demand," that is, a shift of
the curve.
 If the demand decreases, then the
opposite happens: an inward shift of the
curve. If the demand starts at D2, and
decreases to D1, the price will decrease,
and the quantity will decrease. This is an
effect of demand changing.
  When the suppliers' costs
Supply Curve change for a given output, the
supply curve shifts in the same
direction.
 producers will be willing to
supply more wheat at every
price and this shifts the supply
curve S1 outward, to S2—an
increase in supply. This
increase in supply causes the
equilibrium price to decrease
from P1 to P2. The equilibrium
quantity increases from Q1 to
Q2 as the quantity demanded
extends at the new lower prices.
In a supply curve shift, the price
and the quantity move in
opposite directions. If the
quantity supplied decreases at a
given price, the opposite
happens. If the supply curve
starts at S2, and shifts inward to
S1, demand contracts, the
equilibrium price will increase,
and the equilibrium quantity will
decrease. This is an effect of
supply changing.
Elasticity of Demand & Supply
 Elasticity is a central concept in the theory of
supply and demand.
 Elasticity refers to how supply and demand
respond to various factors, including price as
well as other stochastic principles.
 One way to define elasticity is the percentage
change in one variable divided by the
percentage change in another variable (known
as arc elasticity, which calculates the elasticity
over a range of values, in contrast with point
elasticity, which uses differential calculus to
determine the elasticity at a specific point). It is a
measure of relative changes.
Demand Elasticity
Price Elasticity of Demand
 Price elasticity of demand (PED) is defined as
the responsiveness of the quantity demanded of
a good or service to a change in its price.
 it is percentage change of quantity demanded by
the percentage change in price of the same
commodity.
 the price elasticity of demand is a measure of
the sensitivity of quantity demanded to changes
in price.
 It is the measure of the way quantity
supplied reacts to a change in price.
 Determinants of PED
 The overriding factor in determining PED is the willingness and ability of consumers
after a price changes to postpone immediate consumption decisions concerning the
good and to search for substitutes (wait and look). [13]The greater the incentive the
consumer has to delay consumption and search for substitutes and the more readily
available substitutes are the more elastic the demand will be. Specific factors are:
 Availability of substitutes: The more choices that are available, the more elastic is
the demand for a good. If the price of Pepsi goes up by 20%, one can always
purchase Coke, 7-Up, Dr. Pepper and so forth. One's willingness and ability to
postpone the consumption of Pepsi and get by with a "lesser brand" makes the PED
of Pepsi relatively elastic.
 Necessity: With a true necessity a consumer has neither the willingness nor the
ability to postpone consumption. There are few or no satisfactory substitutes. Insulin
is the ultimate necessity.
 Proportion of income spent on a good: Most consumers have both the willingness
and ability to postpone the purchase of big ticket items. If an item constitutes a
significant portion of one's income, it is worth one's time to search for substitutes. A
consumer will give more time and thought to the purchase of a $3000 television than
a $1 candy bar.
 Duration: The more time a consumer has to search for substitute goods, the more
elastic the demand.
 Breadth of definition: How specifically the good is defined. For example, the
demand for automobiles is more elastic than the demand for Toyotas which is in turn
greater than the demand for Red Toyota Priuses.
 Availability of Information Concerning Substitute Goods: The easier it is for a
consumer to locate the substitute goods, the more willing he will be to undertake the
search.
 Factors that make demand for a good elastic
 1. There are many substitutes
 2. The substitutes are readily obtainable
 3. The good is a luxury - it is something you can do without
 4. The good is important in terms of proportion of income spent of
the goods
 5. The consumer had plenty of time to search for the substitutes
 Factors that make demand for a good inelastic
 1. There are few substitutes
 2. substitutes are difficult to obtain
 3. the good is a necessity - it is something you have to have
 4. the good is unimportant in terms of proportion of income spent
of the goods
 5. the consumer has little time or inclination to search for
substitutes
Descriptive coefficients of elasticity

Value Meaning

Ed = 0 Perfectly inelastic.

- 1 < Ed < 0 Relatively inelastic.

Ed = 1 Unit (or unitary) elastic.

-∞ < Ed < - 1 Relatively elastic.

Ed = ∞ Perfectly elastic
 PERFECTLY INELASTIC DEMAND

The demand for a good is

relatively inelastic when the
change in quantity demanded is
less than change in price.
PERFECTLY ELASTIC DEMAND

Various research methods are used to

calculate price elasticity:
Test Market
Analysis of historical sales data
Conjoint Analysis
Price elasticity is always negative,
although analysts tend to ignore the
sign. It is always negative due to the
very nature of demand, if the price
increases, less is demanded, thus
quantity change is negative, leading to
a negative price elasticity of demand.
Conversely, if price falls, this negative
value will lead to a negative price
elasticity of demand value.
Income Elasticity of Demand
 Income elasticity of demand (YED) measures the
percentage change in demand caused by a one percent
change in income. A change in income causes the
demand curve to shift reflecting the change in demand.
YED is a measurement of how far the curve shifts
horizontally along the X-axis. Mathematically YED =
(∂Q/∂Y) (Y/Q). Again the partial derivative indicates that
all other determinants of demand including the price of
the good are being held constant. When YED is less
than one (YED < 1) demand is income inelastic. [8]
When YED is greater than one (YED > 1) demand is
income elastic.
A negative income elasticity of
demand is associated with inferior
goods; an increase in income will
lead to a fall in the demand and
may lead to changes to more
luxurious substitutes.
A positive income elasticity of
demand is associated with normal
goods; an increase in income will
lead to a rise in demand. If income
elasticity of demand of a commodity
is less than 1, it is a necessity
good. If the elasticity of demand is
greater than 1, it is a luxury good or
a superior good.
A zero income elasticity (or
inelastic) demand occurs when an
increase in income is not
associated with a change in the
demand of a good.
Cross Elasticity Demand
 Cross price elasticity of demand (XED)
measures the percentage change in demand
for the good in question caused by a one
percent change in the price of a related good.
Related goods are complements and
substitutes. A change is the price of a related
good causes the demand curve to shift
reflecting the change in demand. XED is a
measurement of how far the curve shifts
horizontally along the X-axis. Mathematically
XED = (∂Q/∂Prg)(Prg/Q) where Prg is the
price of the related good.
 the formula used to calculate the
coefficient cross elasticity of demand is
PRICE ELASTICITY OF SUPPLY

 The price elasticity of supply is used to

see how sensitive the supply of a good is
to a price change. The higher the price
elasticity, the more sensitive producers
and sellers are to price changes.
 Formula in calculating price elasticity of supply:
PEoS = (% Change in Quantity Supplied)/(% Change in
Price)