BCom 1st Year Micro and Macro Economics Notes Study Material
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BCom 1st Year Micro and Macro Economics Notes Study Material
Modern Economic Analysis is conventionally divided into two parts: (i) Micro-economics, also called Price Theory and (ii) Macro-economics, also called Income Theory. As the name suggests, the difference lies in the level of aggregation at which economic phenomena are studied.
The prefix ‘micro’in micro-economics is taken from the Greek word ‘mikros’ which means small. Micro-economics is concerned with the study of the individual, i.e., small economic units——the consumers, households, firms, factors of production, individual industries and markets, and so on. It analyses the way in which their decisions interrelate to determine relative prices of goods and factors of production and the quantities of these which will be bought and sold.
The ultimate aim of micro-economics is to understand the mechanism by which the total amount of resources available to the society is allocated among alternative uses. The central concept in micro-economics is the market and much of the analysis is related to the type of market in which the firm operates, in particular, with the degree of competition. The analysis of individual behaviour concentrates on Consumer Demand Theory.
For more than two centuries micro-economics had been the centre of attention of economists. It was known as the theory of value in the 18th and 19th centuries. Many important features of modern micro-economics (price theory) was constructed by the noted neoclassical economist, Alfred Marshall. Other economists who have added to and modified the corpus of microeconomics are Edward H. Chamberlin, Mrs. Joan Robinson, J. R. Hicks and Paul A. Samuelson.
Traditional micro-economics concentrated on Partial Equilibrium analysis. Modern micro-economics places a much greater emphasis on General Equilibrium analysis. In both the cases the emphasis is on equilibrium analysis. Therefore, micro-economics is also called equilibrium theory, whereas macroeconomics is known as disequilibrium theory. The normative sub-branch of micro-economics is known as Welfare Economics.
The contents of micro-economics can be broadly divided into 3 groups, namely;
(1) Product Pricing, sub-divided into: (a) Theory of Consumer Demand, and (b) Theory of Production and Costs;
(2) Factor Pricing, sub-divided into: (a) Theory of Rent, (b) Theory of Wages, (c) Theory of Interest, and (d) Theory of Profits, and
(3) Theory of Welfare Economics.
These are the contents of conventional micro-economics. Recently two other types of micro-economics have developed, namely, (a) New Microeconomics, and (b) New-new Micro-economics.
These two new branches apply micro-economic tools to such topics as unemployment and inflation.
There are four general questions that arise in micro-economics:
(1) What products are being produced and in what quantities? It is a question concerned with allocation of scarce resources among alternative uses.
(2) By what methods are these products produced? There are many technical ways of producing a product such as labour-intensive technique, capital-intensive technique, intensive agriculture, extensive agriculture and so on. Decision has to be taken about the technique to be used for producing a particular product.
(3) How is the output of goods and services to be divided among the members of the society? It is a question of the distribution of income among the factors of production.
(4) How efficient is the society’s production and distribution? The society first decides what goods are to be produced, then it answers how they are produced and lastly to whom they are distributed. In all these it is natural to know whether the production and distribution decisions are efficient.
The concept of efficiency is very important in micro-economics. It is different from the normative concept of just or equitable distribution. Efficiency is a positive concept which answers the question “What is reality like?” The normative concept turns upon the question “What ought to be done?” An efficient method of production is one where it is not possible to produce more of at least one product without simultaneously producing less of any other product, given the method of production. Efficient distribution is that in which a redistribution of output among the members of the society cannot make at least one person better off without simultaneously making another worse off.
As pointed above, micro-economic theory is also known as the price theory. In microeconomic analysis, concerned with individual choices among various courses of action, special emphasis is placed on the role of Prices in business and personal decisions. Economists try to analyse how the prices of particular goods and services are determined and how the prices influence decisions. This preoccupation with prices is the reason why micro-economics is also called the price theory.
Price theory is defined as that part of economics which is concerned with analyzing the ways in which prices are determined in a market economy. It is also concerned with the role they play in solving the problems of resource allocation. The price theory is divided into three sub-theories, namely, (a) a theory of demand which analyses the behaviour of buyers (consumers), (b) a theory of supply concerned with the behaviour of sellers (producers), and (c) a theory of market behaviour which analyses price determination by the interaction of buyers and sellers in various types of market. Thus the contents of price theory are broadly the same as those of micro-economics.
The prefix ‘macro’ in macro-economics is derived from the Greek word ‘makros‘, meaning large. Macro-economics deals primarily with the analysis of the relationship between broad economic aggregates, like, national income. level of total employment, aggregate consumption, total investment, general price level, balance of payments, the quantity of money, etc. It is largely concerned with explaining the determinants of the magnitudes of these ag. gregates and of their rates of change through time.
A major concern of macro-economics is also the role of government expenditure, taxation, government budget and monetary policy in determining the general level of economic activity. The work of macro-economics is:
- to define and analyse the relationship between the aggregates;
- to find the conditions under which the system is in static or dynamic equilibrium;
- to note the characteristics of the equilibrium state; and
- to predict about the consequences of changes in certain key magnitudes, like the level of investment or government expenditure.
Important questions relating to the study of macro-economics are:
(1) Are the country’s resources being fully utilised, or are of some of them lying idle?
We know that there are not enough resources to produce all of the products that people desire. Yet during periods of recession many workers remain unemployed and seek work, factories remain idle though factory-owners want to operate them, raw materials are available but entrepreneurs do not utilize them. In spite of the factors of production being available, they are not used. Macro-economics studies why and how this state of affairs arises and what is the way out.
(2) Is the purchasing power of money constant, or is it being eroded because of inflation?
The economic history of world shows that price levels have sometimes gone up and sometimes have fallen. The causes and consequences of changes in the price level have to be explained.
(3) Is the economy’s capacity to produce goods and services growing from year to year, or is it remaining static?
This question relates to economic growth. Growth, its causes and its different rates in different countries have to be analysed.
The contents of Macro-economics can be put in the following way:
- Theory of Income and Employment,
- Theory of Inflation,
- Theory of Business Cycles,
- Analysis of Government Budgets,
- Theory of International Trade,
- Theory of Economic Growth,
- Macro-economic Policy.
Adam Smith is the founder of the field of micro-economics. Macroeconomics did not exist in its modern form until the publication of J. M. Keynes’ revolutionary book, The General Theory of Employment, Interest and Money. In this book, he developed a theory of what causes unemployment and economic depression, how investment and consumption are determined, how central bank manages money and interest rates, the role which governments play in getting rid of the ups and downs of business cycles. Samuelson says that although “many economists no longer accept his specific theories and prescriptions, the questions addressed by Keynes still define the study of macro-economics today.” And the principal aggregates studied are those suggested by him.
The Role of Marginal Analysis
In economics, margin means that point where the last unit is produced or consumed. A marginal change is a very small increment or decrement to the total quantity of some variables like utility, cost, revenue, etc. Marginal analysis is the relation between such changes in related economic variables. The founders of the neoclassical economics such as J.M. Clark, F.Y. Edgeworth, I. Fisher, Alfred Marshall, V. Pareto, L. Walras and K. Wicksell used marginal analysis to analyse the pricing of goods, services and factors of production.
An individual who wishes to maximize his/her satisfaction will attempt to determine if the consumption of one more unit of the good will add more to his utility than to its price. Similarly, a firm that wishes to maximize its profit will attempt to determine if the production of one more unit of output will add more to its sales revenues than to its costs.
The importance of marginal analysis arisen in two different ways:
(i) One is associated with its use in micro-economics. A larger part of micro-economics is concerned with the analysis of optimizing behaviour, that is, search for the optimum values of particular variables like utility, profit and social welfare or with the analysis of minimizing costs. “The search for optimum values…involves the definition and analysis of marginal concepts, and this is how virtually all the marginal concepts in micro-economics arise.” -Penguin Dictionary of Economics
(ii) The other is its macro-economics applications. The marginal analysis arises in macro-economics not because we are trying to find optimum solutions but because our direct concern is with the effects of changes in certain variables like investment and government outlay on certain other variables like employment and national income. Here too the analysis of the relationship between small changes in variables, i.e., marginal analysis is of direct interest.
The Relationship between Micro-economics and Macro-economics
(i) Need for separate studies: Micro-economics and Macro-economics are viewed as two separate divisions of modern economics. We need a separate theory of macro-economics because there are forces that affect the economy as a whole which cannot be fully or simply understood by analysing individual markets and individual products.
Micro-economics is that branch of economics which is concerned with the behaviour of individual entities such as markets, firms and households. Macroeconomics, on the other hand, is that branch of economics that is concerned with the study of the behaviour of the economy as a whole. The economy is disaggregated into what are believed to be broadly homogeneous categories. The determinants of the behaviour of each of these aggregates is then integrated to provide a model of the whole economy. Thus the two branches form separate fields of enquiry and are different from each other.
Further, we cannot derive the laws about the behaviour of the economic system as a whole or about the behaviour of large aggregates like consumption, investment, savings by simply adding up, multiplying or averaging the behaviour patterns of individual units of the economy. In economics, what is true of parts is not necessarily true of the whole. So the analysis at the micro level has to be separate from that at the macro level.
If the economic system as a whole is the forest, the individual firms and households are the trees of the forest. Though forest is the aggregation of trees, its properties and behaviour patterns are different from those of the trees. Same is true of micro and macro economics.
Increase in individual saving is desirable and proper from the viewpoint of the individual. But increase in aggregate savings may not be desirable from the point of view of the economy as a whole. Higher aggregate savings may cause lower aggregate demand leading to lower employment. Higher savings during depression will lead to further fall in aggregate demand and employment. So higher saving which is a virtue for the individual becomes a vice for the society. It is called the paradox of thrift.
In spite of the need for separate micro and macro theories, there is also inter-dependence between them.
(ii) Inter-dependence between Micro and Macro Economics: It is said that all classifications are arbitrary. On this basis, the exact location of the boundary between micro-economics and macro-economics is a matter of argument. It is common practice to put the activities of the household, the firm, the labour union and the industry in the micro category. While the forces that affect the important aggregates of the economic system, namely, income, consumption, investment and overall economic growth are placed in the macro category.
Donald Dewey says that the “best argument for respecting this division of labour is that a generation of economists has found it to be useful.” But it should also be noted that macro considerations affect the decisions of households, firms, labour unions and industries. Hence micro and macro theories are not totally separate and independent but inter-connected and inter-dependent.
This inter-dependence can be known (i) The theory of relative prices of products and factors forms the basis for the explanation of the determination of general price level. (ii) There are certain areas where micro and macro theories are equally applicable. In micro theory, an entrepreneur in his investment decisions is guided by the expected rate of profit and the rate of interest.
Aggregate investment function of macro-economics is also dependent on these two factors. In the same way the theory of aggregate consumption is derived from the behaviour patterns of individual consumers. Such examples can be multiplied. (iii) As macro-economics is dependent on micro-economics, so is micro-economics dependent macro-economics. Such micro-economic topics as the rate of profit and the rate of interest depend greatly on macro-economic aggregates.
In the beginning macro-economists attempted to develop macro-economics largely independent of any micro-economic foundation. Some theorists went to the extent of dismissing classical micro-economics as obsolete or irrelevant. “It is now generally recognised that this attempt has failed. Significant recent progress in macro-economics has been made precisely by improving the logical connection of the subject with the micro-economic theories of production, consumption, and exchange.” It leads to the conclusion that the study of micro-economic is necessary for a proper understanding of macro-economics. The two are complementary to each other.
Micro-economics and macro-economics are two streams which converge to form modern economics. “At one time the boundary between the two was quite sharp, more recently, the streams have merged as economists have applied the tools of micro-economics to such topics as unemployment and inflation. Yet to develop a full understanding of economics, it is still necessary to explore both sides of the river.”
This point follows from the fallacy of composition as well. To say that “What is true for the individual or part is necessarily also true for the group or whole is a logical fallacy; it is not correct. The correct position is that there are two essentially different levels of analysis at which the economist may derive laws concerning economic behaviour.