Fundamentals of Microeconomics

In this chapter we will discuss:

Nature and Scope of Economics

Relevance of Microeconomics

Difference between Micro & Macro Economics

Scarcity and Choice

Production Possibility Curve

Partial Equilibrium and General Equilibrium Analysis

Economics and Business

Economics is the study of how economic agents or societies choose to use scarce productive
resources that have alternative uses to satisfy wants which are unlimited, and of varying degrees of
importance. For example, due to the increase in the number of automobiles, the consumption of fuel
has increased. Oil has many uses, other than as fuel in automobiles. However, oil reserves are
limited, and at some point, will be completely depleted. In such a situation, society has several
choices: reduce consumption of oil as fuel for automobiles; or reduce its consumption for other uses,
for example, in making plastics; or, maintain existing consumption levels, till all the oil runs out. Now,
to reduce oil consumption, we can use electric cars. But then we have to deal with the problem of
energy generation since electricity generation is still mostly based on coal or gas, both of which are
also limited resources.
Thus, economics can be defined as a social science that deals with the production, distribution and
consumption of scarce resources in an economy. It examines how resources can be optimally
distributed to satisfy the needs of individuals and the economy as a whole. In other words, economics
explains how day-to-day economic activities such as spending money, making purchases, etc., take
place in an individuals life. For example, it explains how an individual exchanges labor for money,
exchanges money for goods and services, etc.
Professor Robbins defines economics as a science which studies human behavior as a relationship
between ends and scarce means which have alternative uses.
Optimum utilization of resources is possible through a proper allocation of the resources. Shortages
and scarcity occur in an economy when people demand more than what is available. This situation
leads to choice - to satisfy one demand, the consumer has to forgo something else. Thus, scarcity
gives rise to transactions, where people exchange goods and services based on their priorities. On the
other hand, if there are unlimited amount of resources, there is no need for choice in the economy. As
there is no scarcity in the economy, there is no need for the choice. However, such a situation can
occur only in an affluent economy or in a utopian economy.
In this chapter we will analyze the scope and nature of economics and the importance of
microeconomics in the business world. Microeconomics examines various issues faced by individuals
and firms and suggests ways to allocate scarce resources to attain maximum output with the
available resources. The chapter also looks at different market structures under which economic
decisions take place, like the market economy, the command economy and the mixed economy, and
how efficiently these economies allocate scarce resources between different alternatives to meet the
economic needs of their societies.
NATURE AND SCOPE OF ECONOMICS
Economics can be viewed as a science or as an art. It can also be classified as pure economics and
applied economics, or positive and normative economics.
To understand the nature of economics better, we must know what science is. Science can be defined
as a systematic body of knowledge that explains the relationships between causes and effects.

In economics, relevant facts are systematically collected, classified and analyzed. Another
characteristic of science is that its results are easily measurable. In economics, money is used as a
measuring rod for organizational and individual economic activities.
However, a few economists disagree with the classification of economics as a science. A science must
be capable of formulating laws explaining the circumstances under which a particular result can be
achieved, and also the change in the result due to changes in the variables. However, economics often
fails to predict the future course of events accurately due to complex and variable forces involved,
such as unemployment, and price fluctuations. Science is quantifiable where as economics often has
to deal with human attitudes and emotions which are difficult to predict. We cannot predict how an
individual is going to react to a particular situation. This is the case with the economy also. For
example, a shortage in the supply of an agricultural product, say tomatoes, can lead to an increase in
its price. But we cannot assume that this will always happen. If people decide to stop buying
tomatoes because of their high price, and buy other vegetables instead, prices of tomatoes may
remain stable, or even fall.
As economics deals with the wants, needs and demand of human beings, it is sometimes defined as
art. An art, like a science, is a systemized body of knowledge; however, unlike a science, it provides
specific solutions to specific problems. J. M. Keynes defined art as a system of rules for the
attainment of a given end. It is thus often more practical than science, which can sometimes be
theoretical. For example, consumption theory provides us with the law of substitution; this tells a
consumer how to maximize his satisfaction at a given level of expenditure.
Some economists categorize economics into pure economics and applied economics. The well-known
economist Professor Bye defines a pure science as one that furnishes the tools with which applied
science works. The two go hand-in-hand, but the former must precede, for without it the latter is
without the proper means for the accomplishment of its tasks.
Applied economics has gained significance in recent years. Most economists spend their time in
empirical studies in solving the various problems that an economy faces. According to Professor
Stigler, more than 90 percent of economists spend over half their time on applied or empirical
subjects; only a small minority are interested in advanced theoretical discussions.
Another debate about the nature of economics is whether it is a positive or a normative science.
According to J. M. Keynes, A positive science may be defined as a body of systematized knowledge
concerning what is. A normative science or regulative science is a body of systematized knowledge
relating to the criteria of what ought to be and concerned with the ideal as distinguished from the
actual.....The objective of a positive science is the establishment of uniformities; of a normative
science, the determination of ideals.
Positive economics explains economic phenomena according to their causes and effects. At the same
time, it says nothing about the ends; it is not concerned with moral judgments. On the other hand,
normative economics explains how things ought to be. According to Milton Freidman, positive
economics deals with how an economic problem is solved; normative economics on the contrary deals
with how the problem should be solved. A positive statement is based on facts. A normative
statement involves ethical values.
The study of economics helps us understand the nature and causes of economic problems which arise
due to unlimited human wants (which are of varying degrees of importance) and limited resources,
and enables us to develop policies, programs and strategies for dealing with them. Economics helps
us to answer the basic questions pertaining to an economy:

What to produce?

How to produce?

For whom to produce?

Thus we can say that economics is about how society allocates its scarce resources, how the economy
works, how businesses and governments make decisions and how these decisions affect the
individual.

Economic decisions are an integral part of a business whether at a firm level or at an international
level. Knowledge of economics helps a business to become more profitable through proper allocation
of resources, and helps governments in their budgetary and trade related decisions.
Difference between Microeconomics and Macroeconomics
Economics can be broadly divided into microeconomics and macroeconomics. Microeconomics is the
study of the economic system from the perspective of households and business firms; it focuses on
the nature of individual consumption and production units within a particular market or economic
system. On the other hand, macroeconomics deals with the overall performance of the economic
system; it focuses on issues such as unemployment, inflation, economic growth and other problems,
which affect the economy as a whole.
Macroeconomics can be defined as that branch of economic analysis which studies the behavior of not
one particular unit, but of all the units combined together. Thus macroeconomics is a study in
aggregate. Professor McConnell defined both macro and microeconomics. According to him, the
level of macroeconomics is concerned either with the economy as a whole or with the basic sub
divisions or aggregates - such as governments, households and businesses - which make up the
economy. In dealing with aggregates, macroeconomics is concerned with obtaining an overview or
general outline of the structure of the economy and the relationship between the major aggregates
which constitute the economy---In short; macroeconomics examines the forest, not trees. It gives us
a birds eye view of the economy.
On the other hand, microeconomics is concerned with specific economic units and a detailed
consideration of the behavior of these individual units. When operating at this level of analysis, the
economist figuratively puts an economic unit or very small segments of the economy under the
microscope to observe the details of its operation. Microeconomics is useful in achieving a birds eye
view of some very specific components of our economic system.
Microeconomics is the study of decisions that people and organizations make with regard to the
allocation of resources and prices of goods and services. Microeconomics also takes into account
various policies like tax policies and government regulation at the individual level and at the firm
level. Thus it encompasses supply and demand, and other forces that determine price. It helps to
analyze the reasons for variations in price due to increase or decrease in supply, and the factors
influencing the demand and supply. For example, the microeconomic concept analyzes why an
increase in the number of pizza joints in one particular area would cause lower pizza prices in that
area.
Although micro and macroeconomics appear to be different, many issues like production, pricing,
unemployment and inflation are dealt with in both. For example, increased production of automobiles
affects the prices. This is a micro level issue at the firms level. It becomes a macro level issue when
the increased production increases employment opportunities in the economy. Samuelson, a
prominent economist has said, There is really no opposition between micro and macro economics.
Both are absolutely vital. You are less than half educated if you understand the one while being
ignorant of the other. Thus we can see that each economic activity has its impact at micro and macro
levels.
Exhibit 1.1
Difference between Micro & Macro Economics
Microeconomics

Macroeconomics
1. Macroeconomics studies the economy
as a whole.

1. Microeconomics
studies
the
economic behavior of individual
entities
such
as
individuals,
households, firms, industry, etc.

2. Macroeconomics explains about the

total national income, aggregate
demand and supply, general price
level, total employment, etc.

2. Microeconomics
explains
the
inter-relationships
between
economic units like consumers,
commodities, firms, industries,
markets, etc.
3. Microeconomics
analyzes
conditions
for
efficiency
consumption and production.

the
in

3. Macroeconomics
analyzes
the
fluctuations and trends in the overall
economic activity in a country and/or
between various countries in the
world.

4. Microeconomic theory describes

product pricing which explains the
theories of demand, production,
and cost; factor pricing which
explains concepts of wages, rent,
interest, and profit; and the
theory of economic welfare.

4. Macroeconomic theory describes the

theory of income and employment to
explain economy-wide consumption
and investment, the theory of the
general price level and inflation,
theories of economic growth, and the
macro theory of distribution.
5. Macro economic study is vital in the
formulation and execution of economic
policies by government.

5. Understanding
microeconomics
helps a great deal in individual
decision making i.e., managerial
decision-making.
6. Microeconomic analysis helps in
addressing the problems related
to the quantity to be produced,
the procedure to be followed for
production of goods, and the final
consumers
for
the
goods
produced.

6. Macroeconomic analysis includes study

of national aggregates of output,
income, expenditure, savings and
investment.

RELEVANCE OF MICROECONOMICS
Microeconomics plays an important role in the study of economic theory. It helps us to analyze the
behavior of consumers, producers and markets. For example, price can be used as an instrument to
allocate scarce resources among alternative uses. Price helps to determine what goods and services
are produced, how they are produced, and for whom they are produced. An example of this is
telecommunication charges, which are priced differently at peak times and off-peak times, although
the cost of carrying a call over the telecom network is the same during both the periods. Off-peak
charges are set lower to induce increased usage at these times, and thus ensure a more optimum
utilization of network capacity. Thus price can play a crucial role in decision making.
Since price plays such an important role in microeconomics, it is also sometimes referred to as Price
Theory.
Microeconomics has both theoretical and practical significance. This is discussed in the next section.
Importance of Microeconomic Analysis
Maximizes resource utilization
The allocation of scarce resources between competing requirements is a significant problem in any
economy. Similar problems of choice also occur at the level of the individual - i.e., the problem of
satisfying multiple wants with a limited amount of money.

Microeconomics attempts to find solutions to such problems at the individual level and the firm level.
It looks at optimizing resource utilization, and tries to arrive at means to promote economic efficiency.
Advocates market economy
To ensure efficient allocation of resources and capital, and to attain self-sufficiency, microeconomics
advocates a free market economy where demand and supply determine the allocation of resources. If
demand is high for a particular product, and supply is less than the demand, its price will increase. A
market economy will automatically produce more of the product, to reap the profits from the higher
price. Consequently, supply increases, and prices drop, till a normal price level is attained. Thus in a
free market economy, there is no agency or intermediary planning or controlling events or the
market. Instead, consumers and producers make their choices based on the market forces of demand
and supply.
Basis of welfare economics
According to Professor A. P. Lerner, Microeconomic Theory spells out the conditions of efficiency (i.e.,
for the elimination of all kinds of inefficiency) and suggests how it can be achieved. These conditions
can be of greatest help in raising the standard of living of the population. Much of welfare economics
is based on price theory or microeconomics.
Provides tools for evaluating economic policies
Microeconomics deals with consumption and production, and helps explain the hindrances to
achieving production efficiency. It also identifies measures to overcome these impediments.
Construction and use of models
To have a better understanding of economic phenomena, simple models are useful. Economic models
can be abstractions or simplification of the real world. They can be explained in words, or with
numerical tables, graphs or algebra. According to Professor A. P. Lerner, Microeconomic theory
facilitates the understanding of what would be a hopelessly complicated confusion of billions of facts
by constructing simplified models of behavior which are sufficiently similar to the actual phenomena
to be of help in understanding them. The models at the same time enable the economist to explain
the degree to which the actual phenomenon departs from certain ideal constructions that could attain
social objectives. Thus they help not only to describe the actual economic situation but to suggest
policies that would most successfully and most efficiently bring about desired results and to predict
the outcomes of such policies and other events.
Limitations of Microeconomics
Microeconomics deals with the individual perspective, not the aggregate economy. What is applicable
to an individual may not be true for an economy. Wage cutting may help a particular firm; but if all
firms in an industry cut wages, it will have a negative effect on the economy.
Microeconomics uses assumptions such as full employment in the economy, and that other things will
remain unchanged when one particular variable is changed. However, such assumptions may often be
invalid. For example, an assumption of full employment will not hold true for an economy where
underemployment is the norm.
Microeconomics does not analyze the economy as a whole. It deals with specific parts of the economy,
and tries to provide solutions to specific problems.

SCARCITY AND CHOICE

Inflation, unemployment, pollution, energy shortages and government deficits are some of the
complex problems confronting an economy, which have an impact at the micro level also. These
problems arise due to the fact that resources are limited while human wants are unlimited. This leads
to dissatisfaction, causing human being to look for ways to fulfill their needs. Thus scarcity leads to
the necessity of making choices. Problems of choice arise at all levels - at the level of the individual,
at the level of producers, and at the level of the overall economy.
The problem here is to find a method to maximize the level of satisfaction, with the resources
available. Let us now look at how consumers, producers and governments try to satisfy their needs.

Scarcity results when natural resources, human resources and capital resources are not available in
sufficient quantity to satisfy all wants. So a producer has to decide what he wants to produce using a
particular resource. For example, if he chooses to produce paper for textbooks from a stand of trees,
then no other product can be produced from that particular stand of trees. Yet, there are many other
products that could have been produced using the same natural resource, which are also desired by
consumers. The opportunity cost of the decision thus becomes an important consideration; by making
a choice, the next best alternative good cannot be produced.
Consumers typically make their decisions based on two considerations- budget constraints and
personal preferences. A budget constraint is the difficulty a person faces when he tries to satisfy his
unlimited wants with a limited income. Thus, a purchase decision is based on income, price, and
personal tastes and preferences.
A consumer can have a choice of alternative products with a limited income if he can find a person
with whom he can exchange goods or services. By means of such exchanges, he can increase his
level of satisfaction. Such gains in satisfaction can be termed as gains from trade.
Such exchanges are also possible for producers. Although two producers may both be capable of
producing two products, each can also choose to produce the one product in which he has a
comparative advantage over the other.
Comparative advantage explains how trade benefits nations through more efficient use of resources.
For example, Canada and California produce both oranges and milk. In Canada, oranges are produced
in green houses, which leads to high production costs. In California, climatic and other factors
favorable to the production of oranges result in low production costs. At the same time, the cost of
producing milk is higher in California when compared to the cost of producing oranges.
In such a situation, California can produce oranges and sell them to Canada. California has a
comparative advantage in orange production as the cost of production is higher in Canada. Similarly,
even if we assume that the cost of producing milk is higher in Canada than in California, it is still
possible for California to produce only oranges, and buy milk from Canada.
To make the best use of economic resources, the following questions need to be answered:

What to produce?

How to produce?

For whom to produce?

These questions need to be asked because resources are scarce, and can be put to alternative uses.
Let us now examine these questions in greater detail.
What to produce?
At the level of the government, scarcity of land, labor and capital means that they cannot satisfy all
the needs of the economy. They have to choose which goods and services to produce, with the limited
resources available. From an individuals point of view, he or she has to decide how much to consume
and how much to save.
How to produce?
This looks at the combination of resources and the quantity of each resource to be used to produce a
given level of output. The best combination is the full employment of the available resources, to
produce the maximum output. Depending on the resources available, techniques of production can be
labor intensive or capital intensive.
For whom to produce?
This refers to the distribution of goods and services between different categories and sections of the
population. For example, one needs to see if the scarce resources are being used appropriately to
cater to the needs of the higher income groups and the lower income groups.
The answers to these fundamental questions will depend on the extent of government control on the
economy. Economic systems can be classified into three broad categories - the market economy, the
command economy and the mixed economy.

Let us now look at how these economic systems deal with the fundamental issues of what, how and
for whom to produce.
Market Economy
This economic system emphasizes the freedom of individuals as consumers and suppliers of
resources, and allows market forces to determine the allocation of scarce resources through the price
mechanism. Based on market demand and supply, consumers are free to buy goods and services of
their choice and producers allocate their resources based on the demand. Decisions made by
producers and consumers are influenced greatly by price. Any increase in the price of a product
without a corresponding increase in cost increases profit; as a result, producers allocate more
resources to that particular product. On the other hand, if consumers do not like to buy a product,
supply would exceed demand and price would fall, resulting in a lower profit or even a loss to the
producers.
Thus, price plays a major role in a market economy. The role of the government is negligible:
consumers choose the goods they want and producers allocate their resources based on the market
demand for different products.
In such a system, efficiency is achieved through the profit motive. Producers make goods at the
lowest cost of production, and consumers get higher value goods and services at lower prices. The
United States is an example of a market economy; here, firms decide the type and quantity of goods
to be made in response to consumer demand. An increase in the price of one good encourages
producers to switch resources to the production of that item. Consumers decide the type and quantity
of goods to be bought; a decrease in the price of one good encourages consumers to switch to buying
that item.
Command Economy
In a command economy, all the economic decisions are taken by the government what to produce,
how to produce and for whom to produce. Thus, all decisions, from the allocation of resources to the
distribution of end products, is taken care off by the government. In this type of systems, efficiency
can be achieved only when demands are accurately estimated and resources allocated accordingly.
The USSR was an example of a command economy. The government had complete control over the
economy, and consumers were just the price takers. The government set output targets for each
district and factory and allocated the necessary resources.
Incomes are often more evenly distributed in a command economy, in comparison to other types of
economies. Prices are controlled and this allows for greater equality in the economy. Decisions are not
based on individual tastes and preferences, but on national goals.
Mixed Economy
A mixed economy is a combination of a free market economy and a command economy. Here,
government controls the price fluctuations to achieve certain objectives such as high level of
employment and low level of inflation. A mixed economy uses cost-benefit analysis to answer the
fundamental questions discussed earlier - what, how, and for whom to produce. A cost benefit
analysis helps to assess the full costs and benefits to society arising from a particular decision or
project. Decisions or projects affecting the economy as a whole are taken or accepted only when the
social benefits from the decision of project are greater than the social costs.
In a mixed economy, the government organizes the manufacture or provision of essential goods and
services such as education and health care.
Production Possibilities and Opportunity Costs
Now let us analyze how individuals, producers and other economic agents use the scarce resources to
meet the unlimited needs. This to a large extent is possible with the help of the production possibility
curve (PPC). The production possibility curve can be defined as a curve which shows the maximum
combination of output that the economy can produce using all the available resources.

Resources
Production is the process of using the services of labor and other resources to make goods and
services available. Resources are the inputs required for production, and consist of land, labor, capital
and entrepreneurship.
In addition to the sites used for construction of structures and facilities, land includes natural
resources such as forests, rivers and minerals. Services of the physical and intellectual capabilities of
human beings form labor. Capital is the equipment, tools, structures, materials and skills created to
produce goods and services. Entrepreneurship is the talent to develop products and processes and to
organize production to make goods and services available.

PRODUCTION POSSIBILITY CURVE

The production possibility curve helps us understand the problem of scarcity better, by showing what
can be produced with given resources and technology. Technology is the knowledge of how to produce
goods and services.
The following assumptions are made in constructing a PPC:
a.

The economic resources available for use in the year are fixed.

b.

These economic resources can be used to produce two broad classes of goods.

c.

Some inputs are better used in producing one of these classes of goods, rather than the other.

d.

Technology remains unchanged during the year.

Let us look at an example of the production possibility curve. Consider the production of two goods,
say rice and cloth. Table 1.1 shows different combinations of the two goods that can be produced.
From the table, we can see that at production possibility C, with the resources available, we can
produce two tons of rice and 12,000 meters of cloth. However, if we want to increase the production
of rice to three tons, resources have to be diverted to the production of rice from the production of
cloth. As a result, the production of cloth will drop to 9000 meters. In fact, if we want to produce 5
tons of rice, all our resources will have to be utilized for this, which means that we will not be able to
produce any cloth at all (production possibility F).
Thus, to increase the production of one item, we have to forgo the production of some units of the
other item. Looking at the table, we can see that to increase rice production by one ton (from two
tons to three tons), we have to forgo the production of 3000 meters of cloth. In this case, the
opportunity cost of the additional ton of rice is the value of the 3000 meters of cloth forgone. An
increase in the production or consumption of one good can be achieved only through the opportunity
cost of the other good.
Opportunity costs are a result of scarcity. As resources are scarce, producers deciding to produce a
certain good have to sacrifice the next best alternative good that could have been produced with the
same resources. The value of the good given up is the opportunity cost. This might be better
understood with an example. A child with Rs 10 in hand can purchase a soft drink or a candy bar,
both of which cost Rs.10. He can either have a drink or a candy bar, but not both. By choosing the
drink, he has to give up the chance to have a candy bar. The real cost of the soft drink was the candy
bar he could not purchase. This is also true of production decisions made when resources are limited.
There is always a next best alternative product whose production has been sacrificed. In other words,
there is always an opportunity cost when production choices are determined.
Figure 1.1 shows the production possibility curve, based on the data given in the table. The slope of
the PPC shows how much of one good has to be sacrificed, to produce another good. In other words,
we can say that the curve explains the opportunity cost.
Table 1.1: Production Possibility Schedule
Production Possibilities

Rice (in tons)

Cloth (in 000 meters)

0+

15

14

12

From the Table 1.1, we can see that increasing the production of rice from one ton to two tons causes
a fall of 2000 meters in cloth production; and moving from two tons to three tons of rice production
results in a 3000 meter drop in cloth production. So the opportunity cost of the second additional ton
of rice is greater than the opportunity cost of the first additional ton. As we concentrate on producing
more and more of a particular good, the opportunity cost keeps on increasing. As a result, the PPC is
concave to the origin.
Figure 1.1: The Production Possibility Curve with a Given Technology

The PPC does not give the desirable point of production; it only indicates the possible combinations of
the two goods that can be produced with the available resources. In other words, the PPC helps us
find out the combinations of outputs that can be produced with the available resources in an
economy.
The PPC shows the maximum possible combined output of the two goods. All the points on the curve
represent points at which the economy operates at its full productive capacity, that is, all the factors
of production are fully employed. Points L and M on the curve (Figure 1.2) represent full utilization of
resources. However, in any economy, actual production may fall short of the capability. In such a
situation, we obtain a point inside the curve, such as point N, which indicates that resources are not
completely utilized, i.e., there is unemployment in the economy.
Figure 1.2: PPC with Full Utilization of Resources

The PPC illustrates the notion of scarcity by showing that, given the available resources and
technology, production possibilities are limited; and at a given level of output of one good, once the
maximum production possibility of the other good is reached, any increase in the production of the
second good can come about only with a reduction of output of the first.
In the long run, given increases in the availability of resources and improvements in technology, the
PPC can shift outward. This outward shift of the curve represents growth of the economy. The three
main sources of economic growth are:

Increase in the quantities of economic resources available,

Improvement in the quality of resources, and

Advances in technology.

Consider the effects of a change in technology in the agricultural sector. Developments in agriculture
biotechnology have increased the yield of many crops, and improved their resistance to pests and
disease. At the same time, because of the use of pesticides, the losses have decreased. Thus, the
application of agriculture biotechnology has not only improved the quality of the plant but also
increased the yield. As a result, the PPC will shift outwards.
Technological developments enable higher productivity even with other factors of production
remaining constant. Consider the same example of rice and cloth (Figure 1.3). The curve AF
represents the existing production scenario. The technological changes that might take place in a
period of five years will result in increased production capabilities, even with other factors remaining
the same. This means more quantities of both rice and cloth are produced. In such a situation the
production possibility curve will be A'F', indicating the increase in output or growth in the economy.
Figure 1.3: PPC along with Technological Development

Uses of the PPC

The uses of the PPC are discussed briefly below:
Knowledge of economic efficiency: The PPC shows whether an economy is utilizing its resources
fully. If the resources are not used fully, it will be below the curve.

10

Distribution of the national income: The production possibility curve tells us about the distribution
of the national income. For example, if a country produces more cars (luxury items) than food and
clothing, then there is likely to be an inequality in the distribution of wealth.
Choice of the techniques of production: The critical factors determining the technology of
production are labor and capital, i.e. whether production is to be labor- intensive or capital- intensive.
The choice depends on the economic conditions of the country like - availability of capital, technology
and size and economic distribution of population.
The PPC conveys two important messages to a firm. First, it indicates the limited number of
production possibilities during a given period of time. Second, it shows the maximum amount of any
good that can be produced with the available resources. Points on the PPC represent the possible
alternative combinations of two goods that can be produced in an economy, assuming that no other
products are made. Each point on the PPC indicates the maximum amount of one good that can be
produced, given the output of the other good. To reach a point on the curve, resources must be fully
utilized and there should be no mismatch in production. With a given amount of resources and a
certain type of technology only a limited amount of a good can be produced.

PARTIAL EQUILIBRIUM AND GENERAL EQUILIBRIUM ANALYSIS

Partial equilibrium analysis (PEA) and general equilibrium analysis (GEA) are two different approaches
for analyzing the functioning of an economy with inter-related markets.
Partial Equilibrium Analysis
PEA was popularized by an English economist, Alfred Marshall, in the 19 th century. PEA studies a
market in isolation as it facilitates the detailed analysis of the impact of forces in a particular market,
such as the forces of demand and supply as related to changes in price. In PEA, the market under
study is isolated from the rest of the economy. In PEA, each product or factor market is considered as
independent and self-contained for a proper explanation of the determination of price and quantity of
a commodity or a factor.
Limitations of PEA
PEA sets a framework to learn the functioning of each market in an economy. However, it is not
applicable when there is interrelationship between commodities or between factors of production.
Further, it is very complex to apply PEA to understand how an economy functions as a whole. In fact,
in the actual functioning of an economy, the demand and supply of one commodity influences the
prices of other commodities in the market. For instance, when the demand for automobiles goes up, it
influences the price of fuel and the raw material for manufacturing automobiles, which includes steel,
rubber, glass, etc. But PEA ignores all these interrelationships.
General Equilibrium Analysis (GEA)
As PEA is not applicable for analysis of markets that are interdependent, GEA is applied. GEA, which
takes into consideration simultaneous equilibrium of all markets, is employed to study the economy as
a whole.
When the economic system as a whole is considered, there is a great deal of inter-relationship and
interdependence between the various markets for commodities and factors of production, and there
are large number of decision-making agentsconsumers, producers, workers, and other resource
owners. All these agents are assumed to behave in a way that maximizes their satisfaction. GEA
focuses on how the different factors function simultaneously in the economy.
Though GEA is more comprehensive in scope than PEA, both PEA and GEA are useful in their own
way. PEA provides an explanation for determining price and quantity for a given product or factor
market when each market is independent and viewed in isolation. GEA, on the other hand, explains
simultaneous equilibrium of markets when prices and quantities of products and factors are
considered as variables.
In this way, both PEA and GEA are useful and have to be applied appropriately according to the
requirements of the study.

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ECONOMICS AND BUSINESS

As the economic, political and social environment changes constantly, the success of a business
depends on how managers anticipate and cope with these changes. To have a better understanding of
the changing environment, managers have to analyze economic problems at two levels at the
microeconomic level and at the macroeconomic level.
Business economics deals with the application of economic theory to analyze problems faced by a firm
while making decisions. Even at a basic level of business, firms face problems such as the selection of
a product to manufacture and sell. After a product is selected, there is the problem of deciding the
quantity to be produced, and the price to be charged to customers. To find an answer to this problem,
the firm can look at the demand for the product, and its cost of production. Business economics helps
explain how economic forces affect a firms working, and also identifies the possible consequences of
decisions taken by the firm. In other words, business economics can be described as the use of the
theories and technique of modern economics for decision making in business firms.
Managers use their knowledge of the microeconomic environment to analyze the operations of a firm
in its immediate market, including the factors influencing its prices, revenues, costs, etc. Knowledge
of the macroeconomic environment allows a manager to analyze the impact of the external
environment on his business. The external environment includes political, legal and economic
decisions at national and international levels. Thus to make effective decisions, managers should be
aware of the factors that affect business decisions. They must consider issues such as resource
allocation, opportunity costs, diminishing returns, marginal analysis, business objectives, time
dimensions, externalities and discounting while taking decisions.
SUMMARY
Unlimited human wants and scarce resources force people to make choices between various goods
and services. Economics tries to provide solutions to the problem of scarcity and choice. The field of
economics is divided into two areas; microeconomics and macroeconomics. In this chapter we
discussed the importance of microeconomics. We examined how it provides answers to questions like
what to produce, how to produce, and for whom to produce. We have discussed the difference
between microeconomics and macroeconomics. We also studied the various kinds of economies:
market economy, command economy and mixed economy.
As individuals have to choose between alternatives, opportunity cost plays a significant role in the
decision making process. With the help of the production possibility curve, the economy can look at
ways to utilize its limited resources. Partial equilibrium analysis (PEA) and general equilibrium analysis
(GEA) are two different approaches for analyzing the functioning of an economy with inter-related
markets.

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