Micro Economic Analysis

MICRO ECONOMICS ANALYSIS AND BUSINESS POLICIES A business firm has to formulate a number of economic and managerial policies such as production policy, sales policy, advertising policy, purchase policy and investment policy etc. In deciding these policies both, Micro-economic analysis and Macro-economic analysis, are very useful. There are two branches of economic analysis, Micro-economic analysis and Macro economic analysis. Micro-economic analysis is that branch of knowledge in which a particular firm or industry is studied. Unlike this Macro-economic analysis is that branch of knowledge in which the study of whole economy or study of a large aggregates or averages is made. Micro Economic Analysis Micro-economic analysis is the branch of knowledge in which the study of particular economic unit is made. It can be a particular person, a particular firm or a particular industry. According to Henderson and Quandt, “Micro-economics is the study of economic actions of individuals and well defined groups of individuals.” According to Prof. Boulding, “Micro-economics is the study of particular firms, particular households, individual prices, wages, incomes, individual industries and particular commodities.” Scope of Micro Economic Analysis Micro-economic analysis is related with particular or individual units. Marginal analysis is an essential tool of micro-economics and all the laws based on it are studied in Microeconomics. Following studies are made in Micro-economics: 1. Allocation of Resources in the production of Goods and Services : In any economy the quantity of the means of production is limited in a short period. What to produce, how to produce and how much to produce are decided on the basis of allocation of resources. In a free capitalistic economy the allocation of resources to different productions and services depends on the prices of resources. This is the reason that Micro-economics is called “Theory of Product Pricing” also. In Micro-economics both, Theory of product pricing and Theory of Factor pricing are studied. Theory of product pricing, clarifies the process by which the prices of commodities like wheat, cloth, tea, milk, scooter, car etc.whereas the Theory of factor pricing tells us how the price of using land called rent, the price of using labour called wages, the price of using capital called interest and the rewards or return for entrepreneur’s work called profit is determined. 1

2. Allocative Efficiency : Allocative efficiency is connected with welfare economics. It includes efficiency in consumption, efficiency in production and over all efficiency in consumption and production. Role of Microeconomics Analysis in Formulation of Business Policies : Microeconomic analysis plays important role in formulating the policies of the firm and solving different economic problems, these problems are as follows: 1. Helpful in understanding the Mechanism of Economic System: Microeconomic analysis explains how this economy of free enterprise functions without any central regulating body and also throws light on the fact that fully centrally controlled economy cannot aperate well. 2. Effects of Government Policies on Business Firms and Efforts for Positive Change: Business firms can make use of Microeconomics analysis in evaluating state’s economic policies and in trying to improve them. A Business Economist can suggest to the government to adopt those policies by which inefficiency can be eliminated from the economy to maximize the welfare of the people. 3. Investigation of Conditions of Economic Welfare : Microeconomic analysis tells us that the economic welfare will be optimum when there is perfect competition in product market and factor market. But on account of monopoly and imperfect competition there is bad allocation of resources and less than maximum welfare is achieved. It also suggests measures to eliminate wastage of resources and helps in achieving optimality which in turn is helpful in achieving the state of optimum welfare. 4. Providing Tools of Decision Making : Microeconomic analysis also helps the management in realizing its pre-determined objectives and makes the tools required for it available to them. 5. Solving Internal Problems of Operations : Microeconomic analysis, through various methods, helps in solving internal problems of operations of a firm. It helps management in the choice of commodity, choice of scale of production and choice of technology for the production etc. 6. Helpful in Determining Prices : The Theory of product pricing and the Theory of Factor pricing studied in Microeconomic analysis provides immense help to managers in determining prices of their products and prices of factors of production. 7. Analysis of Problems of Taxation : The government imposes many kinds of Taxes on income and production. Sales Tax and Excise duty, for e.g. are imposed on sale and production respectively. A firm can evaluate the effects of such taxes on its production and sale etc and make changes in its policies to avoid their bad effects, with the help of the study of Microeconomic analysis.

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8. Demand Forecasting : With the help of the study of Microeconomic analysis a firm can plan its production in accordance with the demand forecast made for its products. This enables the firm in getting maximum return from its resources. 9. Cost and Production Analysis : Microeconomic analysis helps business firms analyse their cost and production and make necessary changes in the policies regarding them. It can try, if found necessary, to control and reduce the coat of production. Production analysis can help management replace costly resources with the cheaper ones and less productive resources with the more productive. 10.Profit Planning and Control : The success of a firm is measured by the profit it earns. Microeconomic analysis is of great help to the firms in profit planning and control. 11.Measurement of Managerial Efficiency of the Firm : If the management of the firm succeeds in achieving different targets of the firm it is efficient otherwise inefficient. Activities of a firm can be analysed in the light of its targets and actual accomplishments through Microeconomic analysis and necessary action can be taken to induce efficiency through improvement in the fields and areas found inefficient. Limitations of Microeconomic Analysis Following are its main Limitations : 1. Analysis of Micro activities only : Only individual units are analysed in Microeconomic analysis. As a result we are not fully aware of the whole economy. Things which are correct about an individual unit are not necessarily correct about a group in the same way. 2. Based on Unrealistic Assumptions : Microeconomic analysis is based on the two assumptions (a) Other things remains the same and (b) there is full employment in the society. Both these assumptions are unrealistic. 3. Some of the Economic Problems cannot be studied through Microeconomic analysis : In every country there are many problems of national level which cannot be analysed by Microeconomic analysis. Public finance, Fiscal policy, Monetary policy, Economic planning, national income and employment are among many such problems. 4. It does not Study the whole Economy : Microeconomic analysis does not study the whole economy but only certain parts, organizations and units of it. Knowledge of the whole economy is not required through its study. Positive and Normative Economics Economics deals with both POSITIVE and NORMATIVE questions.

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According to J.M.Keynes, “A positive science may be defined as a body of systemized knowledge concerning what it is, and normative science as a body of systematized knowledge relating to criteria what to be and concerned, therefore, with the ideal as distinguished from the actual.” In positive economics we study only facts and make generalizations from them. According to Robbins, Economics is concerned only with the study of economics decisions of individuals and society as positive facts but not with ethical considerations of these decisions. There is a complete elimination of value judgments in positive economics. Positive economist do not consider themselves as social reformers but only theoretics and analysers what the facts say about a particular aspect or economic phenomenon. Normative economics, on the other hand, lays down the basis and criteria for doing things. It is not ‘How’ that is important, it is ‘Why’ which is important. It is based on ethical considerations, ‘What is the best’ is only idea behind them. It is natural that normative economics can not do anything without value judgments (or ethical considerations) and this makes Alfred Marshall’s welfare approach as a part of normative science. Normative science is not only concerned with alternative policy options, it also involves the policy choices. For example, we can judge the desirability of tax on diesel or import duty on diesel. Sometime equity outweighs economic efficiency or sometimes otherwise. Element of Complementarity between the two : In Fact. We can not say that both analyses are opposed to each other. The society cannot go without both. For analyses and theoretical implications it is positive aspect that is to be studied but how far the society is being affected by it, and, whether the effect is socially desirable are the questions to be addressed by the normative economics. Therefore, there is an element of complementarity between the two rather than competitiveness. No science can be completely divested of social value and much less the science of economics. In laying down of scientific laws it may be treated as pure science(positive) but as a tool of practical application it must have certain normative objectives to be fulfilled. Positive analysis is central to the subject of economics but their social desirability and applicability, at large, is the subject-matter of normative economics whish is no less essential for the economic analyses. ECONOMIC SYSTEMS Economic system may be defined as an arrangement by which the central economic problem like what to produce, how to produce and how it should be distributed among the society etc; are settled. Basically there are three types of economic system: CAPITALISM According to Loucks and Hoots “Capitalism is a system of economic organization featured by the private ownership and the use for private profit of man-made and nature-made capital.” Following are the principal features of capitalism:

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(1) Private Ownership of Property. Private ownership of property refers to the right vested in the owner to own and enjoy the property in the manger he likes best. Individuals are free to own not only consumer goods but also producer goods, such as, land, capital equipment, machinery, etc. The institution of private property is indispensable for the proper and smooth functioning of capitalism. But the right to own property is not absolute. It is subject to the overall control of the State. The State may, if it thinks it necessary in public interest, impose restrictions on the use and enjoyment of private property. (2) The Right of Inheritance. Closely connected with the right of private property, is the right of inheritance which is another basic institution of capitalism. If the right of inheritance were abolished, the existence of private property could not support capitalism for long. Even this right is not held absolute. It is being increasingly interfered with by governments in capitalist countries in the form of death duties or inheritance taxes. (3) Freedom of Individual Initiative. This can be interpreted in several senses. As a producer, an individual is free to engage in any business activity that he desires, provided he complies with the law of the State. As a consumer, the individual is free to spend his money in any way he likes. “Under capitalism,” it is said, “the consumer is the king.” It is his preferences which determine what shall be produced by the community. But this consumer’s sovereignty is not absolute, being subject to several limitations. As a worker, the individual is free to choose any occupation he likes, or to sell his labour to any employer who pays him the highest wage. As the owner of a factor of production, say capital, the individual can utilize it in the way that brings him the maximum returns. So every individual is free, with certain limits, to further his or her own interests. (4) Competition. This is a basic feature of capitalism. It is, in fact, essential for the continued existence of capitalism. It results in the establishment of free markets where normal or fair prices are charged for goods. Competition is an institution that promotes efficiency in the actual working of a capitalist economy. The rival producers have always to be on the alert to avoid wastage and cut down costs to capture the market. The existence of a monopolistic market cuts at the very roots of a capitalist economy. (5) Profit Motive. It is often referred to as the “key institution” or the “heart of all the institutions” of capitalism. In fact, capitalism would be unthinkable without the basic institution of profit motive. Every business enterprise in a capitalist economy is governed by the profit motive. Everyone tries to maximize his profits irrespective of what happens to the community as a consequence thereof. Whatever the case, capitalism cannot continue to exist without the ‘prop’ or ‘support’ of the profit motive. In fact, it is the profit motive which affords the springboard for all economic activities under capitalism. (6) Economic Inequality. A capitalist economist is marked by the existence of glaring economic inequalities among the people. The handful few roll in luxuries and wealth, while the vast majority are faced with hunger and starvation. (7) Division of Society. As a result of vast economic inequalities, the capitalist economy becomes split up into classes and groups – the most important division being that of ‘masters’ and ‘men’,

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‘capitalists’ and ‘labourers’ or ‘haves’ and ‘have-nots’. Such a grouping of society directly leads to the emergence of class war which is highly detrimental to the progress of well-being of society. (8) Inequality of Opportunities. A capitalist economy with its glaring inequalities cannot provide for equality of opportunities to all the citizens. The poor and the non-privileged would always start with a handicap and would have to content themselves with only ‘subordinate’ positions however able and intelligent they may be. (9) Concentration of Economic Control in the Selected Few. Still another feature of capitalism is the concentration of economic controls in the hands of a few capitalists, viz., the company directors. The shareholders are mere nonentities, having little or no voice in company administration, though theoretically and legally the final powers vest with them. Advantages of Capitalism The following advantages have accrued from the working of capitalism: (1) Automaticity. An important advantage of the ‘traditional’ type of capitalism is its automatic or ‘selfacting’ nature. It works, unlike a socialist economy, without any manipulation on the part of a central authority. There is no human agency charged with the task of operating it. And yet it works as if there was some ‘invisible’ hand operating it and steering productive resources into the right channels. This invisible hand is nothing else than the price mechanism already referred to above. Even if there are some maladjustments, they get automatically corrected through the operations of the price mechanism. (2) Flexibility. One of the principal advantages of capitalism has been its flexibility, adaptability and resilience which have enabled it to change itself from time to time in accordance with the changed circumstances. (3) Risk-taking. Under capitalism, the entrepreneurs resort to bold experimentation and innovations to earn bigger profits for themselves. In so doing, they evolve new production techniques and processes to cut down costs. (4) Technological Progress. Capitalism also accounts for the present technological progress in the world. The existence of competition among rival producers leads them to spend more and more money upon the evolving and perfecting of new production techniques which would enable them ultimately to cut down costs in order to beat down their rivals. (5) No Wastage of Resources. The entrepreneurs, in order to maximize their profits, see to it that there is no wastage of any kind going on in the productive process. (6) Democratic Character. Capitalism is democratic in character as opposed to socialism or communism which is dictatorial in nature. What is to be produced and how much is to be produced is determined not by the executive fiats of a Central Authority or of a Planning Commission, but by the wishes and preferences of the general body of consumers which are reflected, as already said, in the price mechanism. The sovereignty of the consumer gives a democratic flavour to the whole system.

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(7) Raising Living Standards. Capitalism, in some of the Western countries, has led to raising living standard for the masses of the people. One has to turn to the U.S.A. to realize the type of prosperity conferred by capitalism. Disadvantages of Capitalism The principal defects and shortcomings of capitalism are as follows: (1) Lack of Coordination. The main defect of capitalism is the absence of any machinery to coordinate the decisions of millions of businessmen and producers functioning in the economy. The millions of businessmen take their own decisions without reference to each other. As a result, very often conditions verging upon confusion may make their appearance in the economy. That is why; Prof. Lerner likens a capitalist economy “to an automobile without a driver”. (2) Trade Cycle. There is now conclusive evidence available to us that the trade cycle is the direct product of the functioning of capitalism. It is now established beyond doubt that certain basic institutions of capitalism, viz., competition, the profit motive and the freedom of individual initiative contribute directly to the operation of the trade cycle. The trade cycle, through its operation, creates a good deal of economic uncertainty and instability which can never be conducive to economic progress. In fact, economic stability is the greatest enemy of healthy business enterprise. (3) Economic Inequality. The existence of economic inequality is major defect which corrodes and undermines the very foundations of capitalism. Capitalism not only permits but also perpetuates economic inequalities. There are certain importance institutions of capitalism, viz., private property, the right of inheritance and the market mechanism which not only create but also perpetuate economic inequalities. Such economic inequalities ultimately produce very harmful repercussions in the economy. (4) Social Parasitism. It implies that certain sections in a capitalist economy attempt to live at the expense of others without making nay physical contribution of their own. Capitalism not only creates, but also maintains and perpetuates them. For example, there are several people in a capitalist economy who live on the income derived from the rent of land. Such people do not put in any labour for their own sustenance, but live rather luxuriously on the exhorbitant rents extorted from the tenants. (5) Economic Insecurity. Still another failing of capitalism is its inability to provide security of income, tenure and employment to the mass of wage earners. American capitalism, though it has brought unparalleled prosperity to that country, has not been able to afford a job to every worker desirous of having it. The workers in private employment never feel secure in their jobs. (6) Wastages of Competition. Competition, which is an important basic institution of capitalism, gives rise to all sorts of wastages of valuable resources. The rival producers must spend adequate funds on advertisements and salesmanship to attract the custom of potential buyers. Lots of money may be wasted merely to oust rivals from the field. Competition also results in unnecessary duplication of staff and industrial equipment in rival firms. (7) Absence of the Welfare Motive. Every entrepreneur attempts to amass the maximum profits without devoting any thought to the welfare of the community. Otherwise, how do we explain the

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conduct of a miller who mixes stones and pebbles in wheat atta or the conduct sawdust as genuine tea? Do these people really think of the grave damage that they are doing to human health by their wicked actions? (8) Economic Contraception. This term refers to attempts made by industrialists and businessmen to create artificial scarcity of goods with a view to making maximum profits at the expense of the public. Capitalism offers businessmen powerful incentives to reduce output and restrict supplies of goods with a view to “profiteering”. In achieving this objective, the businessmen resort to all sorts of unscrupulous practices, such as, price leadership, market sharing, formation of trusts and cartels, price agreements, etc. (9) Capitalism’s Social Costs. The private operation of industries inflicts certain costs upon society which are often referred to as social costs. These social costs may be in the form of industrial diseases, cyclical unemployment, industrial accidents, smoky atmosphere, slums, etc. it is obvious that the private capitalists do not bear these costs, but rather throw their burden upon society as a whole. Prof. Pigou refers to the social costs as “the bankruptcy of capitalism”. (10) Absence of Industrial Peace. Still another failing of capitalism is its general failure to ensure durable industrial peace in the economy. The strikes and lockouts are not only harmful to the parties concerned, but also to society at large. Despite various attempts to improve industrial relations, the problem of industrial peace remains as intractable as ever. (11) Capitalism and Colonial Exploitation. As is well known, capitalism is inseparably associated with colonial exploitation and all that flows from it. Colonial exploitation, as Marx pointed out, is inescapable for a capitalist country. (12) Emergence of Monopoly. Capitalism has led to the suppression of smaller firms by large oversized concerns and the emergence of oligopoly or even monopoly to the utter detriment of the consumers and the workers.

SOCIALISM According to Prof. H. D. Dickinson, “Socialism is an economic organization of society in which the material means of production are owned by the whole community and operated by organs representative of and responsible to the community according to a general plan, all member of the community being entitled to benefits from the results of such socialized-planned production on the basis of equal rights.” An analysis of this definition reveals three main points, viz., (i) ownership of the means of production by the State as representative of the community; (ii) The general planning of economic activity; and (iii) An equitable distribution of national incoming among the people. An essential prerequisite of socialism is the complete ownership and management of the means of production by the State. The means of production may be acquired from private owners by the State either with or without the payment of compensation.

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Advantages of Socialism The principal arguments in favour of socialism are as follows: (1) It secures Coordinated Development. A socialist economy is planned economy and as such it secures a balanced and coordinated development of a country’s resources for raising the living standards of the masses. Unlike capitalism, where there are millions of businessmen, each making his own decision independent of others, there is, under socialism, one supreme Central Planning Authority having complete control over the various aspects of economic life. As such, the Planning Authority is in a better position to secure a coordinated economic development than millions of independent businessmen under capitalism can. Furthermore, a socialistic economy secures a quicker and more rapid economic development than capitalism. (2) It eliminates the Trade Cycle. Trade cycle is the direct outcome of capitalism. Under socialism, however, there is no place for the trade cycle. It stands totally eliminated. (3) It prevents Unemployment. Socialism prevents mass unemployment by assuring a job to every citizen. The entire economic life in a socialistic economy is planned beforehand so that there is little possibility of maladjustments taking place or economic resources being wasted as very often happens under capitalism. Socialism’s ability to provide full employment is its greatest asset; an asset which has secured so much popularity for it among the poorer sections of the community. Capitalism, on the other hand, provides full employment only during wartime. In peacetime, a certain amount of unemployment is always associated with capitalism. (4) It secures Equitable Distribution of National Wealth. A socialistic society, by its very nature, is a classless society. As such, it does not permit class distinctions of rich and poor, high and low. There no classes of ‘haves’ and ‘have-nots’ as are found under capitalism because socialism does not allow private property and inheritance. (5) It eliminates Social Parasitism. Capitalism breeds social parasitism, by giving rise to certain sections, such as, landlords, rent receivers, intermediaries, etc., who live directly at the expense of others without putting in any labour for their own sustenance. But there is absolutely no place for social parasitism under socialism where everyone has to work to earn his bread. (6) It provides Social Security to the Citizens. In socialist countries, excellent social security arrangements have been made to cover the daily risks of life; family and children allowances are liberally given. Old age pensions are awarded to the old and the infirm. The Soviet Union ha perhaps the most comprehensive social security system of the world. (7) It eliminates Class-struggle and Social Friction. A capitalistic economy is marked by constant class-struggles and industrial friction which do a lot of harm to the smooth working of the economy. A socialistic economy, on the other hand, avoids this industrial friction and maintains a continuous and uninterrupted flow of production for the benefit of all concerned. (8) It puts an End to Colonial Exploitation. Capitalism, as Marx said, leads to imperialism, wars and colonial exploitation. Socialism, from this point of view, is superior to capitalism. It does not permit colonial exploitation in any form or shape. Disadvantages of Socialism

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The principal defects and shortcoming of socialism are as follows: (1) Too much Concentration of Powers. A socialistic economy is a state-planned economy. This naturally results in the concentration of too much power in the hands of the State. There is every possibility of the State developing, under such circumstance, into a dictatorship of the worst type, constituting a serious threat to democratic rights. Liberty is the fist casualty in a state-planned economy where all economic decisions are taken through executive fiats. (2) Evils of Bureaucracy. A socialist economy, being a state-planned economy, cannot free itself from the evils of bureaucracy. The bureaucracy generally arrogates to itself roles which it is hardly competent to perform with any measure of success. It is everywhere associated with red tapism and official delays in the execution of economic plans. (3) No Incentive to Improvement of Labour Efficiency. It is said that there is no incentive under socialism on the part of the workers to bring about improvements in their performance. The reason is that in a socialist society all the workers are State employees with fixed grades of salary and other working conditions. Promotion to the higher ranks is governed by seniority rather than merit. As such, there is hardly any attempt at self-improvement. (4) Socialism breeds Dishonesty. Another objection against socialism is that it tends to breed graft and dishonesty among State employees. It is common experience everywhere that s the government control economic life extends, chances of corruption increase in an equal proportion. (5) No Consumer’s Sovereignty. “Under capitalism, “ it has been said, “the consumer is the king.” But under socialism the consumer loses his sovereignty. He cannot dictate, but, on the other hand, must accept what is offered to him. He would have to consume what the State wishes him to consume. A State-planned economy is very often associated with rationing of essential goods and services so that a consumer has to rest content with his fixed quota. There is little of variety too so that there is little to choose. (6) No Freedom of Occupational Choice. It is pointed out by the critics that under socialism there is no freedom available to the workers to choose their occupations according to their desire or aptitude, and that the workers are diverted into different occupations according to the requirements of the State or the exigencies of the situation. Such a criticism may not be entirely without some basis because in a planned economy the manpower resources of the country have to be dovetailed into the general plan of the economy. MIXED ECONOMY This represents the intermediate system between capitalism and socialism. In several countries of the world, it is this economic system which has been accepted by the peoples and governments. India affords an outstanding example of a country which has adopted mixed economy as its economic system, though the declared objective of the Government was to bring about “a socialistic pattern of society” in due course of time. Characteristics of Mixed Economy

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1. Co-existence of Public & Private Sectors: An important characteristic of mixed economy is the existence of two sectors, viz., the private sector and the public sector. The former comprises those business units which are owned, managed and controlled by private enterprises. The public sector, on the other hand, comprises all those units and enterprises which are owned, managed and controlled by the State. The private sector in the mixed economy is generally larger than the public sector, through the latter shows a gradual tendency to expand at the expense of the former. Agriculture, in a mixed economy, is generally considered to be a part of the private sector where the farmer is left free to grow the crops he likes, although the government may attempt to regulate agricultural production. 2. Govt.’s influence on Price mechanism: The government may even influence the price mechanism through various fiscal and economic measures. The government may encourage and facilitate the flow of money and credit to those industries which it considers essential in national interests. 3. Govt. control on private sector: In mixed economy govt. takes various measures to regulate and control private sector. For this purpose it can introduce licensing system or use appropriate monetary and fiscal policies. The government may even go to the extent of fixing minimum prices for the various agricultural products, but the actual task of agricultural production continues to vest in the hands of the peasantry. There is no attempt to collectivize agriculture as is done under socialism or communism. 4. Protection of Consumer’s sovereignty: The concept of consumer’s sovereignty is acknowledged as a blueprint, although in actual practice the government may impose exasperating restrictions on the consumption of certain essential goods and services. The industrial worker, unlike under capitalism, is not left to the mercy of capitalist employer in a mixed economy. He is well protected against capitalist exploitation through factory legislation. He is also provided with an increasing measure of social security to cover the daily risks of life. 5. Reduction in Economic Inequalities: Though a mixed economy does not root out economic inequality altogether, yet efforts are made by the government to lessen economic inequalities to the minimum through economic and fiscal measures. Since the mixed economy is a compromise system, the allocation of resources under it is done partly through the price mechanism and partly through governmental direction. 6. Control of Monopoly: In a mixed economy the govt. adopts various laws, rules and regulations to control and regulate monopolistic malpractices to protect the interest of consumers.

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