Micro economics - Definitions, Scope, Importance, Limitations, Types

Meaning and Definition of Microeconomics:

The word "Micro" has been derived from the Greek word "Mikros" which means 'small' or 'tiny'. Thus, microeconomics is the study of the economic activities of individuals and a small group of individuals. These small groups of individuals may be households, firms, and industries ’ consisting of several firms. Microeconomics explains how and why these units. make decision. Microeconomics studies how consumers choose between goods, how. workers choose between jobs, how a business firm decides: what to produce and, what production method to use. Thus, the main objective of. microeconomics is to study principles, problems and. policies related to optimum allocation of resources.

According to K.E.Boulding, " Microeconomics is thé study. of particular firms, particular households, individual prices, wages, incomes, individual industries, particular commodities."

Essentially, 'microeconomics' is a study of particular economic organisms (consumers, producers, etc.) and. their interactions, and of particular economic quantities (prices, wages, incomes, etc.) and their determination.

In microeconomic analysis, each individual unit is examined in a detailed manner in isolation from the general set-up. In other words, the study of a particular unit is made separately at a time rather than the entire unit taken together in general. Therefore, microeconomics is a fundamentally microscopic study of the economy.

Since microeconomics splits up the entire economy into smaller parts for the purpose of intensive study, it is also known as the "Slicing Method".

Microeconomic theory is often called the ‘price theory’ or ‘value theory’ because it is primarily concerned with the determination of relative prices of different commodities. It studies how the combined action of buyers and sellers determines prices in specific markets.

Features of Microeconomics:

The following are the main features of microeconomics:

1. It is individualistic economics. It analyses the behavior of individual economic agents such as individual consumers, households, firms, etc.
2. It assumes that there is full employment in the economy.
3. Microeconomic laws and theories are developed on the assumption of ceteris-paribus.
4. It is applicable under a capitalistic economy where price mechanism plays an important role.
5. Itis also called 'price theory' or ‘value theory’,
6. It is also called the method of slicing because it divides the whole economy into different parts for the intensive study of the subject.
7. Itis concerned with the allocation of resources at the individual level of the economy.
8. Its important variables are individual prices, demand, supply, income, etc.

Scope of Microeconomics

The scope of microeconomics means the subject matter or areas of study under microeconomics. The scope of microeconomics can be explained as follows:

1. Theory of demand: Theory of demand refers to the analysis of a consumer's demand for a commodity and his maximum satisfaction. It studies how a consumer distributes his limited income on the purchase of different goods at different prices to get maximum satisfaction.

2. Theory of production and cost: Microeconomics also studies the theory relating to the production and cost of a commodity. A firm carries out production with the help of factors of production. Under the theory of production, one studies production function and the laws governing the production of goods like the law of variable production and the law of returns to scale, It also deals with concepts of costs, least-cost combinations of inputs, linear programming, etc.

3. Theory of product pricing: Microeconomics also deals with the theory of product pricing. Besides analyzing the conditions of demand and supply, the theory of product pricing seeks to explain how the price of goods is determined under different market conditions, such as perfect competition, monopoly, imperfect competition, etc. The effects of change in demand and supply in the process of price determination are also studied in this theory.

4. Theory of factor pricing: Production is the joint effort of different factors of production. Income received by the sale of goods produced with the help of different factors of production is distributed among the factors of production in the form of factor-price, viz., rent, wages, interest, and profit. How the price (remuneration) of each factor of production is determined is the concern of the theory of factor pricing which is studied under microeconomics.

5. Optimum allocation of resources: Microeconomics is also concerned with the optimum allocation of resources, i.e. how efficiently resources are distributed among the consumers and producers. A consumer or a firm is in equilibrium when there is optimum allocation of resources. Microeconomics, therefore, studies the conditions necessary for achieving equilibrium.

6. Welfare economics: Microeconomics also studies welfare economics. Welfare economics refers to the efficiency in consumption, production, exchange, and distribution. It spells out an ideal economy. It deals with the welfare of people as consumers and producers. -

Importance of Microeconomics

Today, microeconomics occupies a very important role in the study of economic theory. It has both theoretical and practical importance. We may list the importance of microeconomics under the following headings:

1.Helpful to understand the working of the economy: Microeconomics explains the functioning of a free enterprise economy, It tells us how millions of consumers and producers in an economy take decisions about the allocation of productive resources among millions of goods and services.

2. Helpful to formulate economic policies: An economy consists of several sectors such as industry, tourism, trade, and others, An understanding of each of these sectors is imperative before an appropriate policy is designed for them. Microeconomics provides a useful tool to the government while designing price policy, taxation policy, and others in an economy.

3. Helpful inefficient allocation of resources: Microeconomics is helpful in the efficient allocation of resources, Microeconomic theory explains the condition of efficiency in both consumption and production that ensures maximum social welfare.

4. Helpful in the Study of human behavior: Microeconomics studies many forms of human behavior with the help of the law of diminishing marginal utility, equi marginal utility, indifference curve, and revealed preference theory.

5. Helpful in business decision making: Microeconomics is very much useful in business decision making. It helps the business executives in making production plans and trade decisions. It also provides an analytical tool to examine the market mechanisms and helps business firms to take decisions about their production and pricing policies.

Role (Importance) of Microeconomics in Business Decision Making

The role of microeconomics in business decision making can be explained as under:

1. Optimal resource utilization: The productive resources are scarce in the economy and microeconomics tells how the productive resources are allocated in the production of various goods and services. It also helps to find out, what to produce, how much to produce and for whom to produce.

2. Demand analysis: With the help of microeconomic analysis, business firms try to forecast the demand for their product. As we know, the demand for the firm's product would change in response to change in the price of the firm's product, prices of other goods, which may be a substitute or complementary, consumer's income, his testes and fashion, his expectations about future changes in price, changes in the age composition of the population, change in total population, etc. These are the determinants of demand, a study of which is essential for forecasting future demand for the product as well as the present sales.

3. Cost analysis: Cost analysis is an important area of microeconomics. There are many theories to explain the different conditions of cost in microeconomics such as fixed cost and variable cost, average cost and marginal cost, short ran cost and Jong run cost. These all help the business manager to compare costs of production of different periods and thereby to evolve suitable policies in controlling costs and deriving suitable profits.

4. Optimal production decision: The production decision is concerned with the proper product mix. What factors are to be combined in what manner to produce a given product? Microeconomics deals with different production techniques that help to find out the optimal production decision.

5. Pricing policy: We know that pricing of the product is the chief function of a firm, This depends upon the cost of production and at the same time the prices of substitutes and the nature of competition, Price affects profits, which in turn determines the existence and the growth of the firm. The microeconomic analysis provides the business manager a thorough knowledge of the theories of production and pricing to make sure that the firm gets profit continuously,

Thus, the role of microeconomics is both positive and normative. It not only tells us how the economy operates but also how it should be operated to promote the general welfare.

Limitations of Microeconomics

The following are the limitations of microeconomics:

1. Static analysis: In the study of microeconomics, mostly static analysis is used. In it, many economic variables are assumed to be constant. In practice, however, economic variables are changing. Therefore, microeconomics 1s unrealistic to a large extent.

2. Wrong conclusions: The conclusions drawn from the study of microeconomics are in many cases not valid from the point of view of macroeconomics. For instance, in microeconomics, we say that saving is a virtue so far as an individual is concerned but if it is viewed from a macroeconomic angle, that is, if the entire population begins to save more than before, there will be a fall in production and employment. In other words, it will cause misery in the economy. Thus, what is individually a virtue may become socially vice.

3. Unrealistic assumptions: Microeconomic analysis is based on many unrealistic assumptions like the existence of full employment and perfect competition in the economy. But in the real-life situation, both full employment and perfect competition are not found. Hence, the assumptions of microeconomics are unrealistic,

4. Limited scope: Microeconomics has limited scope. The study of many important economic policies and problems like, fiscal policy, monetary policy, inflation, unemployment, etc. are outside its scope.

5. Ignores the role of the government: Generally, microeconomic theories assume the existence of a free enterprise system in which the ‘invisible hands' or market forces are assumed to play their roles freely. Microeconomics assumes also the absence of government intervention in the economic activities of the society. In practice, however, government controls and regulations of economic activities are rules of the day and are all-pervasive.

Types of Microeconomics

Microeconomics is of three types as explained below:

1. Micro Statics

Micro statics is the study of the static relationships between different microeconomic variables. It deals with the final position of equilibrium of these variables at a particular point of time, As such, it is a static analysis, For example, micro static analyses the condition of equilibrium price of a commodity at a particular point of time. However, it does not deal with the process by which the forces of demand and supply have reached the equilibrium position.

The concept of micro statics has been illustrated in the figure below:

In the above figure, DD and SS are demand and supply curves respectively. Point E is the equilibrium point, where DD and SS curves are intersected each other. OP and OQ are the equilibrium price and quantity respectively. As the price, demand, and supply are related to the same point of time, it is a static analysis.


2. Comparative Micro Statics

Comparative micro statics is the comparative study of different points of equilibrium attained at different points of time. It compares one equilibrium position with another when there is a change in microeconomic variables. However, it does not explain the happenings in between the two points of equilibrium. It merely explains and compares the initial equilibrium position with the final one.

 In the above figure, E is the initial equilibrium point where OP is the equilibrium price and OQ is the equilibrium quantity. When demand increases, the demand curve shifts upward from DD to D1D1). Now, the new equilibrium point is E1, where equilibrium price and quantity are OP1 and OQ1 respectively. The comparative study of two equilibrium points E and E1 is called comparative micro statics. But it does not explain the process through which new equilibrium is attained.

3. Micro Dynamics

Microdynamics is the study of the process by which the equilibrium position moves from one point to another as a result of change in microeconomic variables. It explains all types of changes that occurred between two points of equilibrium positions. It analyses the process of happenings in the market during the period of transition from one equilibrium point to another.

The concept of microdynamics has been illustrated in the diagram below:

In the above diagram E is the initial equilibrium point. When demand increases, the demand curve shifts upward from DD to D1D1. This means demand is exceeding supply that exerts upward price pressure. This increases the price from OP to OP1. At price OP1, demand is less. than supply. This exerts downward pressure on price. This process continues in different steps (as shown by the points a, b, c, d, ...) until the new equilibrium is obtained. The arrows show the process of change. Thus, microdynamics shows the process of adjustment from one equilibrium point to another.