LECTURE NOTE ONE

INTRODUCTION TO MICROECONOMICS

Microeconomics is a branch of economics that focuses on the behavior of individual

agents within an economy. These individual agents include; households, businesses

firms, workers, and investors and the choices they make regarding the allocation

of limited resources. Unlike macroeconomics, which examines the economy as a

whole (aggregate), microeconomics deals with the smaller-scale decisions. That is,

individuals try to maximize satisfaction (utility), the business firms try to minimize

cost and maximize profits.

DIFFERENCES BETWEEN MICROECONOMICS AND MACROECONOMICS

The distinction between the two areas of study can be seen in the following areas:

1. Microeconomics deals with the study of economic activities of individual and

small groups of individuals which includes particular households, particular

firms, particular industries, particular commodities and individual prices.

While macroeconomics deals with aggregates of these qualities, that is, the

general price levels (inflation), the general output (GDP) and the national

income.
 2. The objective of microeconomics on demand side is to maximize utility

whereas on the supply side is to maximize profit at minimum cost. On the

other hand, the main objectives of macroeconomics are full employment,

price stability, economic growth and favourable balance of payment.

3. While macroeconomics studies the total amount of employment of major

factors of production, microeconomics studies how the employed resources

are allocated among their alternative uses.

4. Macroeconomics is concern with the allocation of total resources and total

expenditure between consumer goods and capital goods. Microeconomics

usually deals with the allocation of resources at a more disaggregated level.

The Concept of Consumer Behaviour

1. Demand and Supply

 Demand: Refers to how much of a good or service consumers are willing and

able to purchase at various prices.

 Supply: Refers to how much producers are willing and able to sell at various

prices.

 The interaction of supply and demand determines the market price of goods

and services.
 2. The Concept of Utility:

In economics, utility refers to the satisfaction, happiness, or benefit that a

consumer derives from consuming a particular commodity or good and

service. It is a key concept in microeconomics, as it helps explain consumer

behavior—why people make certain purchasing decisions and how they

prioritize their needs and wants.

A. Cardinalist Approach:

The cardinalist approach was central to early economic theories of

consumer behavior. According to the Cardinalist, utility or satisfaction

satisfaction derived from consuming a particular good can be measured in

“Cardinal” or “Utils” or in absolute terms, much like height, weight, or

temperature. According to them, consumers can assign precise numerical

values to their levels of satisfaction, allowing for direct comparisons of

utility levels across different goods and services.

Key Features of the Cardinalist Approach:

1. Measurable Utility:

o Utility can be measured in absolute terms, often in hypothetical units

called "utils."
 o For example, a consumer might assign 10 utils to the utility they get

from bread and 20 utils from consuming meepie, indicating that the

meetpie provides twice as much satisfaction as the bread.

2. Additivity of Utility:

o Since utility is measurable, it can be summed across goods. The total

utility from consuming a combination of goods is simply the sum of the

utility of each good.

3. Marginal Utility:

o The cardinalist approach introduces the concept of marginal utility,

which is the additional satisfaction (utility) gained from consuming one

more unit of a good.

o The law of diminishing marginal utility states that “as consumption of

a particular commodity increases, the marginal utility (satisfaction)

derived from each additional unit decreases”.

Assumptions of the Cardinalist Approach:

1. Rationality:

o Consumers are rational decision-makers, meaning they seek to

maximize their total utility given their income and preferences.

2. Measurability of Utility:
 o Utility can be measured in concrete units (utils), and consumers are

aware of the exact level of satisfaction they derive from each good.

3. Diminishing Marginal Utility:

o As the quantity of a good consumed increases, the additional utility

(marginal utility) derived from consuming each extra unit decreases.

o For example, the first slice of pizza might give a consumer 10 utils of

satisfaction, but the second slice may give only 7 utils, and the third,

4 utils.

4. Total Utility: Total utility of a basket of goods depends on the quantities of

the individual commodities. ie, x1, x2, ……xn.

U = f(x1,x2,………xn)

U = U1(x1) + U2(x2) + ……. + Un(xn).

5. Constant Marginal Utility of Money:

o The utility of money is assumed to be constant. This means that each

additional dollar spent provides the same level of utility.

o This assumption simplifies analysis but is often criticized, as the

marginal utility of money may decrease as wealth increases.

6. Utility is Additive:
 o The total utility derived from consuming multiple goods is simply the

sum of the utilities from each individual good. For example, if

consuming 2 apples provides 15 utils and 3 bananas provide 10 utils,

the total utility from consuming both would be 25 utils.

7. Independent Utility Functions:

o The utility derived from one good is independent of the utility derived

from other goods. This means the consumption of one product does

not affect the utility of another, though this assumption may not hold

in real-world situations where goods can be complementary or

substitutes.

Limitations of the Cardinalist Approach:

1. Subjectivity of Utility:

o It is difficult to measure utility in absolute terms, as satisfaction is

subjective and varies between individuals. This makes the idea of

measuring utility in exact numerical units (utils) problematic.

2. Marginal Utility of Money:

o The assumption of a constant marginal utility of money is unrealistic.

As people become wealthier, the additional utility they gain from an

extra dollar tends to decrease.

3. Interpersonal Comparisons:

o While the cardinalist approach assumes utility can be compared across

individuals, this is generally rejected because people experience

satisfaction differently.

4. Modern Consumer Theory:

o The cardinalist approach was largely replaced by the ordinalist

approach, which focuses on preference rankings rather than

measurable utility. Modern economics generally adopts the ordinalist

view, where utility is seen as a way to rank preferences without

assigning specific numerical values.

B. Ordinalist Approach:

The ordinalist approach, developed by economists such as Vilfredo Pareto

and later popularized through the work of Hicks and Allen, is more

realistic in terms of actual consumer behavior. It simplifies the analysis

of preferences by focusing on ranking rather than measurement, making

it more widely applicable in economic theory. The approach focuses on

how consumers rank their preferences rather than assigning specific

 numerical values to their satisfaction (or utility). where consumer utility

can be measured and quantified.

In the ordinalist view, consumers are assumed to have the ability to rank

different combinations of goods and services in terms of preference, but

they cannot say by how much one option is preferred over another. The

ranking reflects the consumer's preferences, but there's no need to

measure the exact level of satisfaction.

Assumptions of the Ordinalist:

Ordinalist analysis relies on the following assumptions:

i. Rationality: Consumer is rational aiming to maximize his uility given

his income and market prices. (assumed that he has full knowledge

about the market)

ii. Utility is Ordinal: Consumers can rank all possible consumption

bundles.

iii. Diminishing Rate of Substitution: Preferences are ranked in terms

of indifference curves, which are assumed to be convex to the

origin. This implies that the slope of the indifference curve

increases. The slope of the indifference curve is called the MRS of

the commodities.
 Total Utility: Total utility depends on the quantities of the

commodities consumed. U = f(q1,q2,…… qx,qy ……qn)

iv. Consistency and Transitivity: It is assumed that the consumer is

consistent in his choice, ie, if a consumer prefers bundle A to bundle

B, and bundle B to bundle C, they will also prefer A to C.

v. Convexity: Consumers prefer a balanced mix of number of goods

over extremes of just one good.

Here are key elements of the ordinalist approach:

a) Indifference Curves:

Indifference curves show combinations of two goods that provide the

consumer with the same level of satisfaction. Each curve represents a

different level of satisfaction, and the consumer is indifferent

between the combinations on a given curve.

Higher indifference curves represent higher utility levels (more

preferred combinations), but there's no numerical measure of how

much higher the utility is.

Properties of the Indifference Curve:

 a. An Indifference Curve has a negative slope, which denotes that

if the quantity of one commodity (y) decreases, the quantity of

the other (x) must increase, if the consumer is to stay on the

same level of satisfaction.

b. The further away from the origin an Indifference curve lies,

the higher the level of utility it denotes.

c. Indifference curve do not intersect. If they did, the point of

their intersection would imply two different levels of

satisfaction, which is impossible.

b) Utility Maximization:

Consumers aim to maximize their satisfaction (utility) given their

budget constraints. This is done by selecting a combination of goods

that places them on the highest possible indifference curve while

staying within their budget.

The point of tangency between the consumer’s budget line (which

shows the combinations of goods they can afford) and an indifference

curve is where the consumer maximizes utility.

c) Marginal Rate of Substitution (MRS):

The ordinalist approach uses the concept of Marginal Rate of

Substitution (MRS) to explain consumer behavior. MRS measures how

much of one good a consumer is willing to give up in exchange for more

of another good while keeping utility constant (i.e., remaining on the

same indifference curve). At the optimal choice, the MRS equals the

ratio of the prices of the two goods.