EC116

Introductory
Microeconomics Analysis
1. Introduction
Economics, whether you look it in a micro or
macro perspectives, is mainly concerned with
scarcity of the economic resources.

Economists are enthusiastic to understand

how the scarce resource can be used,
allocated or distributed among the people
so as to maximize their level of satisfaction
or in economic jargon, their level of utility.
2
Introduction cont….
While economic resources are scarce the
human wants are unlimited, people want
more than the resource can provide them.
You can think of yourself what you want,
Good cars, big standard houses, Music
systems and things of the like.
However what you have in your pocket to purchase all
what you want, the resource you have (think of cash
money) are not enough to buy all goods and services
you want.
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 Introduction cont….
Economists thus are eager to see how the
resources you have can be used in the best
way to buy those goods and services so that
you get the maximum satisfaction or
happiness. Simply we can say economics is
the study of how to economize scarce
resources.
The word Economize is controversial to
many people who are not economists or do
not have economic knowledge.
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Introduction cont….
Most individuals think that to economize is
to have for example Tshs 500,000; spend
little fraction of it and save the remaining.

However, in the spirit of the word economics

this is not the case. To economize means to
use the resources in the best way (even if
you use all Tshs 500,000) so as to maximize
the satisfaction or simply happiness/utility.

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Introduction cont….
Thus economists are not misers as many
would believe; rather they are efficient in
utilizing the resources to maximize people’s
happiness/utility.
Some writers use different approaches to
express economic ideals, some use
mathematics, some use descriptions and
simple graphs and most use all approaches.
In the course for simple understanding we
will use both approaches.
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1.1 Definition
What Is Economics? People make choices as
they try to attain their goals. Choices are
necessary because we live in a world of
scarcity.
Economics is the study of the ALLOCATION
of SCARCE resources to meet UNLIMITED
human wants.
 Scarcity: A situation in which unlimited
wants exceed the limited resources available to
fulfill those wants; Economics is the study of
these choices.
 Definition cont……..
 Economics studies how the society decides what,
how and for whom to produce goods and services
using scarce resources to satisfy unlimited wants.
 Economists study these choices using economic
models, simplified versions of reality used to
analyze real-world economic situations.
 Economics is a part of social sciences that
describe human behavior in relation to production,
exchange, consumption and distribution.
2. Economics; A science or an art?
Economics is about human behaviour yet we
describe it as a social science rather than a
subject within art or humanity.

This is because the description of economics

reflect the way in which economists describe and
analyze economic problems by developing
theories of human behaviour and test them
against facts.
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Economics; A science or an art? Cont......

Although it differs significantly with natural

sciences as it does not have a specified
laboratory, yet the economic system as a
whole save as a laboratory because within it,
hypothesis and theories are tested against
real world facts.

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3. The uses of Economics
 Economics knowledge serve people in
understanding the society, manage their
own life and improve the world as a whole.
 It helps improve knowledge of crucial
national issues such as unemployment,
inflation, world economic crisis etc.
 Economics play two distinct roles in
promoting the analysis of national issues
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The uses of Economics cont

It helps to understand the society
to describe it, explain and predict
economic behaviors e.g. the causes of
inflation, poverty and unemployment.

 Upon understanding the society,

this knowledge will help to design
policies that will build a better society.
4. Typical “Economics” Questions
We will learn how to answer questions like these:
• How are the prices of goods and services
determined?
• Why does government control the prices of
some goods and services, and what are the effects
of those controls? But you can also use economics
to answer questions like…
• Why do people have so many (or so few)
children?
• How do people choose between hours spent
working and hours spent relaxing?
5. Three Key Ideas
Fact 1: People Are Rational
Rational: Using all available information to
achieve your goals.
Rational consumers and firms weigh the
benefits and costs of each action and try to
make the best decision possible.
Example: a producer doesn’t randomly
choose the price of its product; it chooses the
price(s) that it thinks will be most profitable.
 Three key ideas cont ……
Fact 2: People Respond to Economic
Incentives
Example: Changes in several factors have
resulted in increased obesity in Americans
over the last couple of decades, including:
 Decreases in the price of fast food relative
to healthy food
 Increased availability of health care and
insurance, protecting people against the
consequences of their actions
 Three key ideas cont……
Fact 3: Optimal Decisions are made at the Margin
Marginal cost and benefit (MC and MB): the
additional cost or benefit associated with a small
amount extra of some action.
Example: Should you watch an extra hour of TV, or
study instead?
o What are the benefits of an extra hour of TV?
o What are the costs (i.e. the benefits of studying
instead)?
(Comparing MC and MB is known as marginal
analysis.)
6. Definition of Microeconomics
This is the branch of economics which deals
with the microscopic individual elements of
economic system and not system as a whole.
It deals with the choice and decision making
behaviors and the relationship between price and
quantity of goods and services among
economic agencies in an individual level.
 For example, Household, Firms and other
individual markets.
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 Microeconomics
◦ Microeconomics studies specific economic units and
a detailed consideration of the behaviour of these
individual units
◦ Microeconomics seek to explain the workings of
individuals, firms, households, individual prices,
wages, particular industries
◦ Microeconomics is the study that focuses on
individual decision about particular commodities. It
analyzes the behavior of individual components like
firms and households and how the prices are
determined by market mechanisms
6.1 Microeconomics vs
Macroeconomics
Macroeconomics on the other hand emphasizes on
interaction and the functioning of the economy as a
whole and examines how the level and growth of output
are determined.
It analyses inflation, employment, asks about total
money supply and investigates why some countries in the
world are striving while others are stagnating.
Thus macroeconomics is mainly concerned with
aggregate behaviors, relationship and nature of variables
such as national income, total consumption, saving and
investment, total employment, price level, aggregate
expenditure and supply. 19
Microeconomics vs Macroeconomics
Though macro and micro economics are
two different concepts yet they are
interrelated and complimentary parts of
economics.
 For example determination of general wage level is a
subject of macroeconomics but determination of
wage in a particular industry is the subject of
microeconomics.

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Microeconomics vs Macroeconomics…..
However when we take decision
regarding wage rate in a particular
industry, this decision will definitely
be influenced by the prevailing general
wage rate in an economy.

Thus macroeconomics affects

microeconomics and vice versa.
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6.2 Main components of Microeconomics
• Microeconomics also known as the Price
Theory
The main components of microeconomics are
as follows:

Theory of Supply
Theory of Demand
Theory of Price determination
Theory of factor price
Main Components ……. cont
1. Theory of Consumer Behaviour: This
theory study how consumers attain maximum
satisfaction with his given income and how he
chooses from various alternatives

2. Theory of Producer Behaviour: This

theory study how producers attain maximum
profits by producing and selling products
worth given level of resources and technology
Main Components ……. cont
3. Theory of Price: This theory studies
how price is determined in the market,
although at points where demand and
supply curved meet. That point is fixed as
price

4. Theory of factor prices: As we know

that persons pay rent and wages to avail
factors of production
6.3 Main topics
Microeconomics is concerned with the
following topics
1.Commodity Pricing:
Prices of individual commodities are
determined by market forces of demand and
supply.
So Microeconomics makes demand analysis
(individual consumer behaviour) and supply
analysis (individual producer behaviour)
Main topics
2. Factor pricing:
Land, labour, capital and entrepreneur, all
factors contribute in the production process.
So they get reward in the form of rent, wages,
interest and profit respectively.
Microeconomics deals with such rewards i.e
factor prices.
So Microeconomics is also called “Price
theory” or “Value theory
 Main topics
3. Welfare theory:
Microeconomics deals with optimum allocation
of available resources and maximisation of
social welfare. It provides answers for:
What to produce
When to produce
How to produce
For whom it is to be produced
In short Microeconomics guides the utilisation of
scarce resources of the economy to maximise
public welfare.
6.4 Microeconomics Subject matter
It deals with determinants of product
prices

In short it is concerned with the

determination of prices like theory of
production , theory of rent, wages, profit
and economic welfare.
6.5 Merits of Microeconomics
A worm’s eye view of a small specific unit
Formulating economic policies and
efficient use of scarce resources of the
country
Achieve maximum output with minimum
costs
It is helpful for Macroeconomic studies.
6.6 Limitations of Microeconomics
It provides a snapshot of the economy
and not the whole economy i.e. the area
of study covered is limited

It cannot be abruptly applied to the

study of macro economic problems
Lecture 2
7. Macroeconomics
Macroeconomics is the study of the
economy as a whole, including topics
such as inflation, unemployment, and
economic growth.

It is the study of economic behaviour of

the economy as a whole and not the
individual economic units of the
economy
Macroeconomics deals not with
individual quantities but with the
aggregates of these quantities,
 not with individual incomes but national
income,
not with individual prices but with price
levels,
not with individual outputs but with
national output
 7.1 Macroeconomics Subject matter
It deals with total consumption, total
savings, total output or national income,
inflation, deflation and economic
growth

In other words it is concerned with the

analysis of income and employment in
the economy as a whole
 7.2 Main Components
The main components of Macroeconomics
are as follows:
Theory of income and employment

Theory of distribution

Theory of fiscal and monetary policy

 7.3 Merits of Macroeconomics
Provides a bird’s view of the entire
economy
Macroeconomics is more useful in
solution of economy problems
It is quite useful in formulation of
Government economic policies
Study of macroeconomics is useful to
microeconomic studies
 Summing up
Macroeconomic and microeconomic
approaches are inter-related, inter-
dependent and complementary to each
other.

Therefore, they are both necessary for a

perfect study of economics
8. The circular flow model of income (Two Sector
Model)
The circular flow model of income is an
analytical frame work which presents the flow of
goods and services and income from firms to
households or from household to firms via
products or factor market.

The model assume that the economy is operating

at full employment level and the income that are
received by firms or households are all used to
purchase factor inputs and goods and services
respectively.
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The circular flow model of income (Two
Sector Model)……
Figure1.1 The Circular Flow Model of Income (Two sector)

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The circular flow model of income (Two
Sector Model)……
Output Flow
 Household supply factor inputs (land, labor, capital etc.) to
the firms through factor market, the firms transform these
resources into commodities and then supply back to the
households through product market.
Input Flow
 Households receive income (wage, rent, interest etc.) from
firms after selling their inputs in the factor market and spend
all of it to purchase goods and services in the product market.
On the other hand firms receive revenue from selling those
good and services and use the revenue to buy factor inputs
from households.
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Positive
and Normative
Economics
8. The Scientific Nature of Economics
When analyzing human behavior, we can
perform:
◦ • Positive analysis: the study of “what is?”; and/or
◦ • Normative analysis: the study of “what ought to
be?”

Economists generally perform positive

analysis.
8.1 Positive economics and normative economics
NORMATIVE analysis- This can be defined as the
analysis of questions with answers involving value
judgments. The questions being “What ought to be”.

That means from public point of view we analyze

how certain policies used by government are good or
bad. For example, is it better to follow a command
economy, free market economy or mixed economy?

There is no straight answer here as the question

involves value judgments and people’s opinion.
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Positive economics and normative economics……
POSITIVE analysis- This is the analysis
that asks “What is” and does not involve
people’s opinion or value judgement rather it
involves the facts.

So we analyze the consequences of a certain

policy in economic activities. For example,
what are the consequences of fertiliser price
support policy to farmers?

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 Example: Should Medical School Be Free?

Forecasts indicate a significant shortage

of doctors, especially primary care
physicians, by 2020.
Would more people become primary
care physicians if medical school were
free? And if so, would it be worth the
cost?
Economic models can find answers to
the positive aspects of this debate.
ECONOMIC PROBLEM
9. Economic problems
Economic problems are a concern of the use of
scarce resources among the alternatives/unlimited
human wants towards the ends of satisfying
people as fully as possible.
Thus economists are concerned with the issue of
scarcity of resources in the world. In this case we
can say that the fundamental problem in
economics is SCARCITY.
There will be a scarcity of commodities since
those commodities are produced from those
scarce resources.
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 Fundamental Principle of Economic Theory

Fundamental economic questions

48
9. 1 What to produce
A major problem facing a society is decide
what goods and services to produce and in
what quantity they should be produced with
limited resources. Thus for this the
society/country has to make CHOICE.

Choice between consumption goods and capital

goods
Choice between civil goods and war goods
Choice between private goods and public goods
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 9.2 How to Produce
This problem arises because there are more than
one possible ways of which goods and services can
be produced. Thus the problem of how to produce
is basically the issue of technicality. This problem
therefore involves the aspect such as;
Location of production
Techniques of production
The size/scale of production
The ownership of production
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 9.3 For whom to produce
This problem is related with the
distribution of national resources. The
output in an economy is a result of a
combined effort of the various factors
of production.

The question here is how these outputs

should be distributed among factor inputs
or consumers.
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9.4 Resources and factor payments
Resources and factor payments:
a. Land - includes space (i.e.,
location), natural resources, “free
gifts of nature”
and what is commonly thought of as
land.

Land is paid rent

 Resources and factor payments
Capital - are the physical assets used in
production - i.e., plant and equipment.
 Capital is paid interest
Labor - is the skills, abilities, knowledge,
the contribution of human beings and the
effort exerted by people in production
(called human capital) .
◦Labor is paid wages
Resources and factor payments cont….
Entrepreneurial talent - (risk taker) the
economic agent who creates the enterprise. `
◦ Entrepreneurial talent is paid profits

Allocations of resources imply that decisions

must be made, which in turn involves choice.
Every choice is costly; there is always the lost
alternative -- the OPPORTUNITY COST:
 9.6 Scarcity, Choice and Opportunity Cost
The whole discussion on economic problems is
centered on three basic concepts; Scarcity,
Choice and Opportunity Cost.
Scarcity
The term Scarcity implies “limited in supply”.
When we say the resources of the country are
scarce it simply means they are limited in supply.
Economic goods and services are scarce in the
sense that they are not available in sufficient
amount to satisfy or give everyone he/she would
wish to consume.
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 Scarcity, Choice and Opportunity Cost
 Choice
This is concerned with choosing the best
alternative from scarce resources. Every
economic system is confronted with
scarcity of goods and services and of the
production resources available to them.
Hence because of the scarcity the society
is obliged to make choice concerning
what, how and for whom to produce
goods and services.
Scarcity, Choice and Opportunity Cost……..
In the process of making choices we
must sacrifice some resources in order
to obtain the best alternatives. The
next best alternative we forgo is what
is termed by economists as
OPPORTUNITY COST.

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Scarcity, Choice and Opportunity Cost……..
 Opportunity Cost
 Life is full of choices because the resources are
scarce, hence we must constantly decide what
to do with our limited time, money etc. e.g.
should we go to movies or read a book? In
each of these cases making a choice in the
world of scarcity require us to give up
something else. In effect this costs us an
opportunity to do something else. The best
alternative we forgo is known as opportunity
cost.
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 Marginal opportunity cost
Note, the concepts of scarcity, choice
and opportunity cost can be illustrated
in one graph known as Production
Possibility Curve/Frontier (PPC/PPF).

Marginal opportunity cost = the

amount of another good that must be
given up to produce one more unit of a
good.
 9.7 The society’s technological possibilities
The limited resources make goods and
services to be scarce and therefore the society
is required to answer the three economic
questions of what, how and for whom to
produce.

There is a technical style that tries to illustrate

how to make choices and allocate the
resources efficiently. Consider the following
Production Possibility schedule and curve.
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 The society’s technological possibilities……
 Production Possibility Schedule
Possibilities X mill of kg Y mill of kg

A 0 15

B 1 14

C 2 12

D 3 9

E 4 5

F 5 0

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The society’s technological possibilities……
Production Possibility Frontier/Curve

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The society’s technological possibilities……
PPF is the locus of points which show maximum
amount of output the economy can produce given the
technological knowledge and the quantity of inputs.
Producing at point A or F imply that the country
has decided to use all the resources in production of
commodity Y or X respectively. Producing along the
PPF imply that the country is using the resources
efficiently.
Efficientmeans the absence of wastes or using of
the resources as effective as possible to meet
requirement of the people.
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The society’s technological possibilities……

At any point between A and F and along

the PPF, the country reallocates resources
in such a way that some are used in
production of X and others are used in
production of Y. For example at point C
some resources are used to produce 12
units of good Y and some are used to
produce 2 units of good X.

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The society’s technological possibilities ……
Producing inside the curve that is at point
G means the country is using the
resources inefficiently.
In other words the country under employs
or underutilizes the resources.
Point H is said to be unattainable point
because with the available resources and
level of technology the country can only
produce at its maximum level along the
PPF.
 Production Possibilities Frontier (PPF)
A graph of all economically efficient combinations
of goods the society is able to produce.

 The changes in slope in the diagram tell us how

the rate of exchange, or rate of transformation of
goods, between X and Y changes as we continue to
transfer resources from one product to the other.

 The Rate of Transformation on the PPF is the rate

of economically efficient exchange; it tells us the
Opportunity Cost of one good in terms of another.
 Specialized resources in farming
Some land, labor, and capital is better suited for
wheat production and some is better suited for
corn production
Unemployed or underemployed
resources
Points outside of the PPF
 The PPF will shift outward:
If additional productive resources
are made available.
If current available resources
become more productive.
If more productive ways of
combining resources are found.
Economic growth
Commodity-specific technological
change