Microeconomics – A Complete Beginner’s Study Guide – Yes, you read the title right! This is a complete beginner’s guide to microeconomics, not a beginner’s complete guide to microeconomics though it is an effort in that direction to cover as much as possible in a simple manner. I’ve set my intentions clear and you should benefit immensely from this if you are a complete beginner.
- Microeconomics Definition
- Demand, Supply and the Supply-Demand relationship
- Substitution and Elasticity in Microeconomics
- Giffen Goods/ Giffen Paradox
- Veblen Goods
- Income and Inelasticity in Microeconomics
- Opportunity Cost in Microeconomics
- At the Margin and Indifferent Preferences
- Indifference Curves – Microeconomics
Microeconomics is a ‘bottom-up’ approach. It is a study in economics which involves everyday life, including what we see and experience. It studies individual behavioral patterns, that of households and corporates, their policies, how they respond to different stimuli etc. Microeconomics largely studies supply and demand behaviors in different markets that make up the economy, consumer behavior and spending patterns, wage-price behavior, corporate policies, impact on companies due to regulations etc.
Please note that this is very different from the definition of Macroeconomics. You may find the following guides useful –
Demand, Supply and the Supply-Demand relationship
This drives any economy and market. We buy some item almost every day, be it food related, medicines, electronic accessories and several others. This is ‘demand’ (not that we are too demanding in our approach). It originates from us. Similarly, the shopkeeper demands products from the wholesaler by observing the demand for his/her products by us. On the other hand, the shopkeeper supplies the products to meet our demands and the wholesaler supplies what the shopkeeper asks. This is ‘supply.’ Secondly, we ask for a number of products else, demand a certain number of units for each of the products we buy. The same holds for supply. These are known as ‘Quantity Demanded’ and ‘Quantity Supplied’ respectively.
As the quantity demanded exceeds the quantity supplied over a period, suppliers would either have to increase their supply or else increase the prices of the products being sold – they are having a shortage of stock or quantity supplied. As prices go up, demand would ideally reduce as people may not be able to afford the same products at elevated prices. People may still demand but in lesser numbers. This gives time for the suppliers to get back in action and supply sufficiently to meet the demand.
As the quantity supplied exceeds the quantity demanded, suppliers would either have to cut down on their supply or else decrease the prices of the products being sold – they are having a surplus/excess stock or quantity supplied. As prices go down, demand would obviously pick up and match the supply.
When both, quantity supplied and demanded are optimal, i.e., match perfectly, the result achieved is a ‘State of Equilibrium.’ When they aren’t equal, what arises is either a shortage or excess which gets adjusted to achieve equilibrium again.
The most important rationale behind this is ‘assuming all other factors remaining the same/equal,’ the quantity demanded decreases as price increases and the quantity demanded increases as price decreases (inverse relationship). All other factors remaining the same, the quantity supplied increases as price increases and the quantity supplied decreases as price decreases (direct relationship).
As can be understood from what is read above, the ‘Demand Curve’ is negatively sloped and ‘Supply Curve’ is positively sloped (see the picture below – a straight curve is a line!). Just plot the price-demand, price-supply relationship and you would find out. It’s a D-I-Y (Do It Yourself) assignment!
The graph above is a depiction of the concept of ‘Equilibrium’, the vertical axis (Y-axis) representing ‘Quantity’ demanded and supplied whereas the horizontal axis (X-axis) represents the ‘Price’ of the product/service. The explanation below should make it simpler for you!
[Note: By ‘higher’ and ‘lower’ prices, we mean the price relative to the ‘Equilibrium Price’ – that which a buyer should ideally bid/buy for (OR) the price relative to that which a seller should ideally ask/offer.]
Substitution and Elasticity in Microeconomics
When the prices are higher relative to what one can afford people may prefer cheaper ‘substitute goods’ to what they generally buy – substitution effect. This behavior of change in demand due to price is called ‘price elasticity of demand’ – just like an elastic band which is flexible and changes according to the shape and contours of the object. If coffee is costlier than tea but you also like tea, you would go ahead with drinking tea if the prices of coffee have gone up. Tea substitutes coffee in this example.
Giffen Goods/ Giffen Paradox
Obviously named after Mr. Giffen (Sir Robert Giffen), they are a unique category of goods. What makes them unique is the price and demand equation. We know through economics and common sense that the quantity demanded falls as the price of that good rises. So here are a few examples for you:
- If you follow soccer, you would be aware of the transfer of players to different clubs every season. Often times, good players and their teams demand a higher price for the player being sold by them. The higher the price bid, the more valuable the player and importantly some teams are ever more willing to buy that player even as their price increases.
- A clichéd example – does the demand for salt get subdued because its price is on the rise. People seem to be indifferent to the price.
Even as the price rises, demand doesn’t lurk – Strange. In fact, demand increases as prices rise! To think deeper, people are not really that dumb! These are probably rational decisions, but you are absolutely willing to pay a higher price despite the rise in prices. These types of exceptional goods are called ‘Giffen goods’ where the demand curve is positively sloped. These goods might seem overpriced but on deeper thought, undervalued i.e., they might increase in price but might actually be cheaper than its substitutes. These are not to be confused with the next category of goods!
There are three criteria which Giffen goods have to fulfil to be called such:
- A lack of substitute goods;
- The good bought should be an inferior good (a good where a rise in income would lead to a fall in demand. If your income has risen, you would prefer an Uber taxi to a bus/auto if the latter was your daily mode of transport)
- A good portion of the consumer’s income should be used to buy the product but at the same time, it should not be the case where consumers don’t buy regular products which they do normally (normal goods).
They are similar to Giffen goods yet they are different. These are goods which are seen as a status of esteem, luxury and something for which you don’t mind paying a high price even as prices increase. A typical example is that of the Rolls Royce car, jewellery, gems etc. where the higher prices are, the greater the intensity to purchase that good to show your status such that you end up the purchasing it. Giffen goods are not luxurious by nature like Veblen goods.
Income and Inelasticity in Microeconomics
Giffen and Veblen goods are examples of ‘price inelastic demand’. The demand doesn’t vary due to price which makes it inelastic. There is no need to substitute your demand for that particular good. This might be due to your elevated income levels – part of the income effect as compared to substitution effect. The income you get to spend comes from external sources like salaries etc. and/or a fall in the price of the good you spend on (saving money) and/or sacrificing buying the next best product which might be costlier than the product you currently spend on assuming you buy the best and most beneficial product – the opportunity cost of the product.
Opportunity Cost in Microeconomics
Here, we come to a key concept – ‘Opportunity Cost’ i.e., the cost incurred by not choosing the second best alternative (because we assume you go for the best alternative) given that the choices are mutually exclusive (one choice eliminates the others). In other words, it is the marginal benefit one could derive by choosing the second best comparable alternative to achieve the same purpose given that the choices are mutually exclusive. Put simply, it is an opportunity which you didn’t choose.
Example: You are a 5 year old kid and have $5 with you to choose between an ice-cream and Swiss chocolate which cost $5 and $4 respectively (would a 5 year old kid really care if it were a Swiss chocolate? I doubt he’d know its specialty. Who knows?). Let’s say that the kid chooses the chocolate over the ice-cream just to spoil our clichéd assumption that a kid would always choose the ice-cream! He relishes the chocolate until he sees his friend relishing the ice-cream. The kid then tries to weigh the costs of his decision to go for the chocolate.
At the Margin and Indifferent Preferences
Now we have to understand why such decisions are made – looking at opportunity costs, at our spending behaviors due to income effects, substitution effects and several such related patterns. A good reason to explain it all apart from our intuitiveness is that we look at everything from an incremental standpoint, a marginal standpoint
- How much better would I be if I made the decision of going with ‘X’ over ‘Y?
- How much more should I spend if I go for ‘X’ than ‘Y’?
- At what point will I be totally satisfied that I have as many units of ‘X’ over ‘Y’?
- When will I attain a state of mind where I’m fine with both ‘X’ and ‘Y’ such that both satisfy me equally? At what point will I stop being choosy about both?
Some questions are logical and some are philosophical. Sounds interesting right?
This is where the concepts of Marginal Utility and Marginal Costs kick in!
Marginal utility being the additional benefit you derive by consuming a good/service over another and marginal cost being the extra cost incurred/price paid by consuming that good/service in simple terms.
Indifference Curves – Microeconomics
Till now, we have covered a lot of things in an intuitive way, through common sense and different examples. What governs a horde of the above concepts and principles comes from the study of the famous ‘Indifference Curves.’ Bear with me!!
Refer to the Indifference Points – Microeconomics for an example.
The curve joining the points PAQ above, is from the set of sample data points’ in the Excel sheet (Right Click on the Chart after inputting the sample data points – Change Series Chart Type – Scatter Plot). You would be able to connect the points PAQ through a curve.
What is going on?
Using the sample data in the Excel sheet, you would find out that point A could be looked at like a benchmark. Point A would be preferred against the points on the left-bottom (south-west) of A and; Point A would not be preferred to the points on the right-top (north-east) of A. Obviously you would prefer maximum units of both the goods and thus preferences would move along the north eastern side.
By inputting the sample data points in the excel sheet example, we obtain the following graph and conclusions:
- A would clearly be preferred to B,Y and R with B being preferred the least
- Z would clearly be preferred to A
- Points C and P have more drinks than A but lesser food; X and Q have more food than A but lesser drinks – we need greater information about how the customer would choose between the above based on the money he has, tastes, reviews, rankings etc.
The customer may choose to be indifferent between P, A and Q. If the three are connected through a line, we get an Indifference Curve. Given PAQ is your indifference curve (the choices you are indifferent to), points C, Y, R and X will not be preferred.
The indifference curves could also be CAQ, PAX or CAX, but it can’t be all of them – indifference curves can’t across each other. Why?
Let A be your benchmark and PAQ, your curve. Assume CAX is also your curve where it cuts across PAQ. Point A is indifferent to X and Q. X should be indifferent to Q if the curves cut, but if you required more food, you would prefer Q over X. Thus indifference curves can’t cut across each other.
The shapes of indifference curves can indicate whether and how a customer would be willing to alter his demands by substituting one good for the other. In the above example where PAQ is your, he would be willing to substitute 25 units of drinks for 10 units of food (move from P to A in the graph – you would go down 25 units on the Y-axis and go further 10 units on the X-axis) and 25 units of drinks for 30 units of food (A to Q).
In the simpler initial curve given below, you would substitute 20 units of drinks for 10 units of food (A to B) and so on!
This measure of marginally compromising units of one for the other is called the Marginal Rate of Substitution – for math savvy people, it’s the slope of the curve!
If you plot a budget line on a graph with multiple indifference curves, the maximum benefit would be derived where the budget line and the highest indifference curve is tangential.
The violet line above is the budget line and the point in red is the tangent. That is where the maximum utility would be derived. Although there is a lot more to dive into, this should be good enough for now.
Goodness! This was quite a lot to digest! Not only was it a beginner’s guide to concepts at the core of microeconomics, it also had quite a few ‘do-it-yourself’ exercises like the excel sheet which you can freely configure though it isn’t the ultimate solace to your questions.
Here are a few questions for you to think about:
- If you’ve understood Giffen goods, what do you think will happen if the prices of these goods fall and why? (A part of the solution lies in the explanation)
- Can Veblen goods be Giffen goods?
- We agree that indifference curves cannot cut across each other. Can two indifference curves stay/sit on top of each other?
- Do substitution effects and elasticity have to go together? Do income effects and inelasticity have to go together? (of course I have covered the two effects intuitively and not in great detail, but it’s worth a thought.)
If you think you have understood a good chunk of microeconomics, try answering the above. Think about them. The answers are for you to think and verify through different sources. Good luck, happy thoughts!!!