MICROECONOMICS AN INTRODUCTION

The discipline of Economics focuses primarily on three over-arching issues:

1. How do/should people make choices/decisions to improve their economic well-being?
2. How do individual choices interact to generate aggregate economic outcomes?
3. How does the scarcity of economic resources generate trade-offs in individual decision-
making as well as in aggregate economic outcomes?
Lets elaborate a bit more on these points. Recognize that every economic entity makes
choices/decisions all the time: Individuals make economic choices about human capital
acquisition, occupation, retirement plans, etc.. Businesses make economic choices about
what to sell, how much to sell, who to sell to, etc.. Governments make economic choices
about taxes, money supply, interest rates, etc.
These choices interact to generate aggregate economic outcomes: what kinds of goods and
services are produced (production), how they are traded (allocation), and who consumes
what (consumption).
Economics studies these kinds of interactive decision-making processes, and the aggregate
outcomes that such decisions generate. Of course, such a big issue cannot be studied in full
generality. So Neo-classical Economics (i.e., the Economics that we shall be studying) make
the following substantive assumptions:
(1) all decision-makers are rational, and
(2) no individual or collective entity violates the rule of law.
While the second assumption is straightforward (though unrealistic), the first assumption
requires a formal definition of rationality. In essence, rational decision-making is the
process of making decisions by solving constrained optimization problems this point will
be elaborated upon in our subsequent discussions.
It is clear that everyone should have some familiarity with the discipline of Economics in
order to improve their material well-being. Business school students have all the more reason
to learn Economics it will help them make better economic decisions, and better understand
the economic environment in which they locate themselves. The current course will focus on
the following issues:
[Issue 1] Studying the principles of economic decision-making under situations of scarcity;
[Issue 2] Studying the economic outcomes generated by the aggregation of individual
decision-making, while recognizing the following two-way causation: Individual decisions
are affected by the economic environment, while the environment is itself shaped by
aggregation of individual decisions.
Robinson Crusoe versus Us
To understand why the subject gets quite complicated quite fast, compare the island-economy
of Robinson Crusoe to a modern-day economy. Recognize that Crusoe had to worry about
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[Issue 1] given scarcity of resources available to him, but not about [Issue 2].
Our modern economy has substantial advantages, and some significant disadvantages, over
the Crusoe economy. Our most important advantage is that we can reap the benefits of
specialization / division of labour where different economic agents specialize in
producing different goods and services. But how much we benefit from such specialization
depends upon the functioning of the economic institutions in general and the market
mechanism in particular because it is these institutions that determine how freely and
fairly economic exchanges can take place among different agents. On the one hand, the
extent of competition and coordination determine how well our economic institutions
function. On the other hand, the functioning of our economic institutions determines the
incentives that individuals face to be economically productive.
Consider the terms market mechanism, economic exchanges, competition,
coordination, and incentives. Recognize that none of these terms would be relevant for
Robinson Crusoe, while each of them is an important topic of study in modern
microeconomics. We will study these issues in details, and spend a substantial amount of
time discussing the market mechanism: When does the market mechanism work well, and
when does it not? When it does not, what policy interventions can improve matters?
A Primer on Markets and Market Power
Every market consists of a triadic relationship between firms, their customers, and their input
suppliers. Each firm procures inputs and raw materials from its input suppliers, and uses its
technology to convert these inputs into goods and services that it sells to its customers.
Customers

Active Firms (The Industry)

Input Suppliers
What separates one market from another? The boundary of a specific market is determined
predominantly by (a) the range of products that are closely related in consumption and/or
production, (b) geographical boundaries, and (c) time. Regarding (a), any two products are
considered to be closely related if a small change in the price ratio of the two products lead
to a substantial change in the ratio of their market demands and/or market supplies.
There are three components that determine the structure of a market market structure:
(i) the structure of demand (e.g., whether there are many small customers or a few large
customers), (ii) the structure of input supply (e.g., whether there are many small suppliers
or a few large suppliers), and (iii) industry structure which refers to the size
distribution of active firms in the market.
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The two extreme firm size distributions that are possible are: bilateral monopoly and
prefect competition. In the former case, its a single firm that operates between the input
suppliers and the final consumers, and market is said to be fully concentrated; while in the
latter case, there are numerous small firms that are active in the market, and the market is said
to be fully fragmented. Note that no real-world market is fully concentrated (a single
pharmaceutical company producing a patented drug using unique inputs might constitute the
closest thing to a pure bilateral monopoly), and no real-world market is fully concentrated
(some commodity markets come close).
Most real-world industries the airline industry, the automobile industry, the banking
industry, the telecommunication industry are oligopolies where a few firms sell closely
related products and enjoy significant market shares. Of course, there are variations in firm
size distribution across different oligopolies some are more concentrated (closer to
monopoly) and others are less concentrated (closer to perfect competition).
A central aim of Microeconomics is to uncover the systematic relationship between three sets
of variables: (1) market fundamentals, (2) industry structure, and (3) market power of
different market participants. The demand and the input supply structure, the nature of the
products being sold, and the technology of production are principle constituents of the market
fundamentals; while market power refers to the ability of a market participant to affect the
market price in a way that benefits him/her (for active firms, market power manifests itself in
being able to sustain prices significantly above unit production costs).
Subsequently, we will discuss at length the causal relationships between market
fundamentals, industry structure, and market power. At this time, we briefly discuss the
Structure-Conduct-Performance [S-C-P] theory put forward by the economist J oseph Bain
and his co-researchers in the 1960s. TheS-C-P theory relates market structure, firm conduct,
and market performance in the following way:
Market fundamentals like high entry barriers and significant scale economies lead to greater
industry concentration, i.e., fewer and larger firms in the industry. This concentrated industry
structure leads to monopolistic firm conduct which is associated with the active firms being
able exercise greater market power and sustain prices significantly above incremental costs.
In turn, monopolistic firm behavior leads to greater economic profits for the active firms, and
lower social efficiency.
We shall spend a substantial amount of time explaining and deconstructing the S-C-P theory.
While the theory is valid as a rough approximation in the real world, many qualifiers have to
be added for the theory to represent the market reality. A central problem with the S-C-P
theory is that it treats entry and demand/cost conditions as exogenous explanatory variables.
But in reality, industry concentration is itself affected by firms conduct (and their
performance). That is because entry and exit of firms in the industry responds to how
collusive or competitive firms are, what kind of entry barriers they create, how larger firms
predate small firms etc. Entry and exit, in turn, affect industry concentration. In other words,
both industry concentration and market power are determined endogenously, each affecting
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the other. The devil is in the details, and the details will be studied thread-bare in our
subsequent discussions.
[An aside: Missing markets and Entrepreneurship In some scenarios, some markets do
not operate in spite of positive consumer valuations for products only because sellers have
not discovered profitable ways in which to serve their customers. (For example, the market
for student loans, that is so well developed in India today, did not exist twenty years ago.) A
large part of entrepreneurship is about finding profitable ways to serve unmet demand; the
other part of entrepreneurship is about finding more cost-effective ways of meeting
demand.]
All market transactions occur via prices. So the fundamental role of market prices is to
determine allocations of goods and services (who sells how much and who buys how
much). In addition, market prices play two other important roles. They determine
incomes/profits of different economic agents, and they also convey information about
investment decisions for the future. World crude oil prices at any point in time play three
roles: they determine the allocation of crude oil among different users, they determine the oil
revenues of the oil-producing countries, and they influence new drilling decisions of
different countries.
Subsequently, we will spend a lot of time addressing the question: who sets prices in
different markets? As we will see, the answer to this question will be inherently linked to the
extent of market power enjoyed by different participants in a particular market.