Basic Concepts in Microeconomics helpful for studying

Macroeconomics

Many of modern macroeconomic models require fundamental understanding of

microeconomics. In particular, topics such as economic growth, labour market,
consumption, and international finance often require understanding basic microeconomic
principles. This note is designed to serve two types of students (1) those who never
studied microeconomics before and (2) those who studied introductory economics
somewhere but want a quick self-study refresher course.

1. Market Model: Supply and Demand

The starting point in analysing any market is to employ a simple tool of supply and
demand curves.

A supply curve shows the willingness to supply by sellers. As prices increase, sellers
will be willing to supply more, and hence the supply curve in a market is typically
upward sloping, showing a positive relation between price and quantity supplied.

Demand curve shows the willingness to pay by buyers. As prices increase, buyers
respond by cutting down their demand for the product. Hence, the demand curve for a
‘normal’ good is typically downward sloping.

Putting demand and supply curves together,

P ($) S

P*

Q* Q (Quantity)

The concept of market equilibrium:

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If the quantity demanded equals the quantity supplied, the market is said to be in
equilibrium, and hence there is no surplus or shortage.

In the above diagram, the price and quantity pair which ensures an equilibrium is P* and
Q*.

2. Economic Decision Making: Maximising Utility and Profit

In microeconomics, the most important principle can be summarised by the following

simple rule of thumb.

Marginal benefit equals marginal cost. MB = MC

Why? Suppose that you consume an ice-cream cone, which is sold for $2 per unit.

The first ice-cream cone gives you a benefit (or pleasure) worth $5, as you were so
craving for an ice cream.

What is your net benefit from the initial consumption of an ice-cream?

Simple: $5 (benefit) - $2 (cost) = $3.

Now suppose you are considering having an extra ice-cream cone. Should you buy an
additional ice-cream cone? Yes, why not?

From a second ice-cream cone, you get a benefit worth $3.50, which still exceeds the cost
($2). What is the net benefit this time? $3.50 - $2 = $1.50, which is still positive.

Now suppose that you are contemplating having even more ice-cream cones, say, a third
ice-cream cone, which would give you the benefit worth only $2.50. The net benefit this
time is much smaller at $2.50 - $2 = $0.50, although it is still positive.

What about if you proceed to buy a fourth ice-cream cone?

Suppose that the benefit you get from the fourth ice-cream cone is at best worth $0.50.
Should you proceed? Answer is no. Why not?

If you proceed, the net additional benefit, known as the marginal benefit, from the 4th ice-
cream cone will be $0.50 - $2 = -$1.50, which is negative. So, you should stop at the 3rd
ice-cream cone!

The above example shows that, as long as the marginal (or extra) benefit exceeds
marginal (or extra) cost, you should keep on doing what you are doing until MB = MC.

Once the marginal benefit equals marginal cost, or the marginal benefit from continuing
further is likely to be less than the marginal cost, you should stop doing it. You’ve
already maximized the cumulative net benefit. How do we know?

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For the ice-cream example above, let’s calculate the cumulative net benefits.

No. of ice-cream cones MB MC TB TC Cumulative Net Benefit

1 5 2 5 2 3
2 3.5 2 8.5 4 4.5
3* 2.5 2 11 6 5
4 0.5 2 11.5 8 3.5

where TB = total benefit, and TC= total cost.

Note that the cumulative net benefit is at the maximum at the 3rd unit of ice-cream cone.

The maximum cumulative net benefit occurs at MB = MC or very close to it because ice-
cream cones are not divisible (i.e., you cannot buy 3.5 ice-cream cones).

Note that in the above example a fundamental assumption is that the additional benefit is
diminishing as the individual consumes more of the same good. This is known as the
principle of ‘Diminishing Marginal Benefit (or Utility)’.

In the labour market (important in macroeconomics), households (or workers constituting

households) supply labour hours and firms (or entrepreneurs) demand workers (labour
hours) to produce output.

The quantity supplied or demanded can be measured in hours (or number of labour units).

Then, what is the price of labour?

The price of labour is the wage rate, say, W dollars per hour. The dollar wages we
observe are called the nominal wage. The wages adjusted for the purchasing power or
price level (P) are called the real wage, W/P.

We assume in economics that people are all ‘rational’, and therefore, they are concerned
with the real wage, not the nominal wage. That is, we assume that workers are not fooled
by money illusion! What’s the use of getting paid $1 million dollars if you can only buy a
Big Mac with all of the money! (This actually happened in Zimbabwe!).

Now we need to know how a ‘rational’ (or profit-maximising) firm makes its decision of
hiring workers.

This principle that MB = MC for the maximum benefit can be applied in many contexts.

For firms, maximum profits can be obtained by setting

Marginal Revenue (MR, firm’s MB) = Marginal Cost (MC)

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That is, as long as an extra revenue exceeds an extra cost of producing an extra unit of
output, the firm should keep increasing its output until the marginal benefit (or marginal
revenue) is equal to the marginal cost of production.

In the labour market, the firm will try to hire workers until the MB of hiring an additional
unit of labour equals the MC of it.

Assume that the wage rate is constant and already given (say, e.g. by the minimum
wage) and that all workers are identical (i.e., roughly the same in productivity and
attributes). Then, the MC of hiring an additional unit of labour will be the wage rate.

What about the marginal benefit?

The marginal benefit of hiring an additional unit of labour (worker) can be measured by
the extra (or marginal) contribution (or product) brought by the worker.

The MB of hiring an additional unit of labour therefore becomes the Marginal Product of
the last hired unit of labour (or worker).

Profit maximising firms will therefore equate MPL (marginal product of labour) to w (the
wage rate).

That is, MPL = w.

Note that MPL is a real quantity, or a real variable. Hence, here w is also real wage, not
the money wage.
Therefore, the wage rate equated to MPL is also a real wage, which is given by

w = (W/P)

where W = nominal or money wage, and P = the price level such as the CPI.

Okay, now how do we measure the marginal product of labour?

Marginal product of labour = ∆Y/∆L. That is, a change (increase) in output due to a
change (increase) in labour input. The delta sign ‘∆’ denotes changes.

For a production function how do we calculate this? This is for mathematically confident
students only.

3. Production Function

Suppose that output can be produced using the following technology, expressed as
Y = AKαL1−α, known as a Cobb-Douglas production function.

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That is, output (Y) is a multiplicative function of capital (K) and labour (L) for a given
technology (A), where the parameters ‘alpha’ and ‘1-alpha’ measure capital’s and
labour’s share of output, respectively.

Then, we can express the marginal product of labour as follows.

MPL = ∆Y/∆L = dY/dL = (1-α)AKαL-α = (1-α)Y/L

N.B. Y/L is the average product of labour (APL).

Equating this MPL to the real wage (w) for given values of α, A, and K, one can solve for
Ld, the quantity of labour demanded by the firm. That is, we can determine the quantity
of labour for the firm for profit maximization, once we know the quantities of output,
capital input, and its share of output (‘alpha’) for a given level of productivity (A).

Note that in the ECON1002 lecture note and textbook, we used the MB = MC principle
in nominal (or dollar) terms, rather than in real terms. Given that the price level is
constant, we can use the nominal relation, VMP (value of marginal product) = W
(nominal wage), rather than MPL(marginal product) = w (real wage). This is just a matter
of multiplying the equation by P!

If the supply curve is also known, you can solve for the equilibrium wage and
employment in the labour market.

Now we need the concept of the law of diminishing returns or diminishing marginal
productivity.

The law of diminishing returns says that when you keep increasing one input holding
another input constant output increases but at a decreasing rate.

Graphically,

(Y) Output

∆Y

Input (L)
∆L

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That is, the production function is concave down.

This implies that the marginal (meaning extra or additional) productivity of the input,
measured by the slope of the above production function, is decreasing as output is
increasing.

In the above diagram, the marginal productivity from point ‘a’ to point ‘b’ can be
measured by the change in output over the change in input.

That is, ∆Y/∆L.

If the interval between two such points is infinitesimally small, the marginal productivity
can be expressed using dY/dL, the derivative of Y with respect to L. Graphically, the
marginal product for a very small change is given by the slope tangent to a point on the
curve.