Microeconomics: Choices, Markets and Welfare
Microeconomics studies the choices of individual agents — households, firms, factor-owners — and how those choices interact in markets to allocate scarce resources. It is the analytical bedrock of nearly every applied field, from public finance to labour economics.
The fundamental economic condition that human wants exceed the resources available to satisfy them. Scarcity necessitates choice, and every choice has an opportunity cost.
Demand, supply and equilibrium
The law of demand states that, ceteris paribus, the quantity demanded of a good falls as its price rises. The law of supply says quantity supplied rises with price. Their intersection determines market equilibrium price and quantity.
Shifts in demand come from changes in income, prices of related goods (substitutes and complements), tastes, expectations and population. Shifts in supply arise from technology, input prices, taxes/subsidies, and producer expectations.
| Goods type | Income effect |
|---|---|
| Normal | Demand rises with income |
| Inferior | Demand falls with income |
| Giffen (rare) | Demand rises with price (extreme inferior good) |
| Veblen (luxury) | Demand rises with price for status |
Elasticities
Elasticity measures responsiveness in percentages:
- Price Elasticity of Demand (PED): %ΔQd / %ΔP. Demand is elastic if |PED| > 1, inelastic if |PED| < 1, unit-elastic if |PED| = 1.
- Income Elasticity (YED): positive for normal goods, negative for inferior.
- Cross Elasticity (XED): positive for substitutes, negative for complements.
- Price Elasticity of Supply (PES).
PED determines tax incidence: the more inelastic side bears more of the burden. This is why excises on cigarettes raise revenue effectively in Pakistan — demand is highly inelastic.
- Total revenue test: when demand is elastic, a price cut raises revenue; when inelastic, a price rise raises revenue.
- Elasticity is higher in the long run as substitutes emerge.
- Necessities tend to be inelastic; luxuries elastic.
- Goods with many close substitutes are elastic.
Consumer theory
A rational consumer maximises utility subject to a budget constraint.
- Cardinal utility (Marshall) — utility is measurable; equilibrium where marginal utility per rupee is equalised: MU₁/P₁ = MU₂/P₂ = … = MU_n/P_n.
- Ordinal utility (Hicks–Allen) — consumers rank bundles; equilibrium at the tangency of the highest indifference curve with the budget line, i.e., MRS = P_x / P_y.
- Revealed preference (Samuelson) — derive preferences from observed choices.
The demand curve for a normal good slopes downward due to (i) the substitution effect (always negative) and (ii) the income effect (negative for inferior goods, which can reverse the law in extreme Giffen cases).
Producer theory and costs
A firm transforms inputs into output via a production function Q = f(L, K).
- Short run: at least one input is fixed → law of diminishing marginal returns.
- Long run: all inputs variable → economies and diseconomies of scale.
Short-run cost concepts:
TC = FC + VC
AC = TC / Q
MC = ΔTC / ΔQ
Key result: the MC curve cuts the AC curve at its minimum. The supply curve of a competitive firm is its MC curve above the average variable cost.
Market structures
| Feature | Perfect Competition | Monopolistic Competition | Oligopoly | Monopoly |
|---|---|---|---|---|
| Number of firms | Many | Many | Few | One |
| Product | Homogeneous | Differentiated | Standardised or differentiated | Unique |
| Entry barriers | None | Low | High | Blocked |
| Pricing power | None | Some | Strategic | Significant |
| Example (Pakistan) | Agriculture (wheat) | Garments | Cement, banks | WAPDA / NTDC |
Perfect competition
P = MC = MR; firms earn zero economic profit in the long run.
Monopoly
The monopolist maximises profit where MR = MC, charging a price above MC and producing below the socially efficient level. The wedge produces deadweight loss. Price discrimination (1st, 2nd, 3rd degree) can extract more surplus.
Oligopoly
Firms are interdependent. Models include:
- Cournot (quantity competition),
- Bertrand (price competition),
- Stackelberg (leader–follower),
- Kinked demand curve (price stickiness),
- Cartels (collusion), and game theory (Prisoner's Dilemma, Nash equilibrium).
Factor markets
Wages, rents and interest are determined by the demand for and supply of factors. The Marginal Productivity Theory says each factor is paid the value of its marginal product (VMP = MPP × P). In imperfect markets, the wage is below VMP — the basis for trade unions and the minimum wage.
Pakistan's labour market is highly informal (~70% of non-agricultural employment), which weakens this textbook result and is a frequent CSS exam talking-point.
Welfare economics
- Consumer surplus — difference between willingness to pay and the price actually paid.
- Producer surplus — difference between price received and the minimum acceptable price.
- Pareto efficiency — no one can be made better off without making someone worse off.
Market failure
Markets misallocate resources when there are:
- Externalities (e.g., emissions from brick kilns near Lahore).
- Public goods (non-rival, non-excludable — defence, lighthouses).
- Asymmetric information (Akerlof's Market for Lemons).
- Market power (monopolies).
Government interventions include taxes (Pigouvian), subsidies, regulation and direct provision.
For Pakistani context, link textbook failures to live policy: Pigouvian taxes on cigarettes and sugary drinks; subsidies on Kissan Package urea; smog as a transboundary externality; price ceilings on essential commodities through the Utility Stores Corporation.
Game theory and strategic interaction
The Prisoner's Dilemma shows that individually rational behaviour can lead to a collectively inferior outcome. A Nash equilibrium is a strategy profile where no player can do better by unilaterally deviating. CSS papers increasingly include applied questions on cartel stability, OPEC, and bidding rings.
Information economics
- Adverse selection — lemons in used-car markets, high-risk borrowers in credit.
- Moral hazard — insured drivers driving more recklessly.
- Principal–agent problem — managers maximising perks rather than shareholder value.
Solutions: signalling (education), screening (insurance questionnaires), monitoring, and performance-based pay — all directly relevant to Pakistan's banking and SOE reforms.