Micro and macro economics, uses and limitations, statics and dynamics

1. Two approaches: micro and macro

The terms were introduced by the Norwegian economist Ragnar Frisch in 1933. Micro comes from the Greek mikros, small; macro from makros, large.

Micro economics studies the behaviour of individual economic units: a consumer, a household, a firm, an industry, the price of a single commodity or factor. Kenneth Boulding defined it as “the study of particular firms, particular households, individual prices, wages, incomes, individual industries, particular commodities”. Because its central question is how the prices of goods and factors are fixed, it is also called price theory. Its classical expression is Alfred Marshall’s Principles of Economics (1890).

Macro economics studies the economy as a whole and its aggregates: national income, total employment, the general price level, aggregate saving and investment. It is also called income theory, and owes its modern form to J.M. Keynes’ General Theory of Employment, Interest and Money (1936). Principles of Economics (B.A. Sem 1) covers the same distinction in its note on basic concepts and economic laws.

The two are interdependent. The general price level (macro) is an average of individual prices (micro); the demand for a firm’s product depends on national income (macro). Both are needed.

2. Scope of micro economics

• Theory of consumer behaviour: utility, indifference curves, demand and its elasticity (Unit II).
• Theory of production and cost: production function, returns, cost and revenue curves (Unit III).
• Theory of product pricing: price and output under perfect competition, monopoly, monopolistic competition and oligopoly (Unit IV).
• Theory of factor pricing: rent, wages, interest and profit (Unit V).
• Welfare economics: whether a given allocation of resources is efficient.

3. Uses (importance) of micro economics

1. Explains price determination. It shows how the prices of goods and factors are set in different markets.
2. Explains the working of a free-market economy. Millions of independent decisions are co-ordinated by the price mechanism; micro theory shows how.
3. Allocation of resources. It tells us how scarce resources are distributed between competing uses, and when that allocation is efficient.
4. Business decisions. Demand forecasting, cost control, pricing and the choice of output all rest on micro concepts. Managerial economics is applied micro.
5. Public policy. The effect of a tax or subsidy on a commodity, price control, minimum wages and regulation of monopoly are analysed with micro tools. Competition law (the Competition Act, 2002) draws directly on the theory of monopoly and oligopoly.
6. Foundation for macro. Aggregates are built up from individual behaviour, so macro models borrow their assumptions from micro theory.

4. Limitations

• Unrealistic assumptions. It assumes full employment, perfect knowledge and rational behaviour. Full employment is rare in practice, and Keynes’ criticism began here.
• Fallacy of composition. What is true of an individual may be false for the whole. One person saving more becomes richer; if everyone saves more, aggregate demand and income may fall (the paradox of thrift).
• Cannot explain aggregate problems such as unemployment, inflation, trade cycles or economic growth.
• “Other things being equal”: the method holds other variables constant, which they seldom are.

5. The problem of choice

Economics exists because wants are unlimited while resources are scarce and have alternative uses. Every society, and every consumer, must therefore choose. This is Lionel Robbins’ scarcity definition (1932) applied: see the Principles of Economics note on definitions of economics. The choice takes the form of the central problems of an economy:

1. What to produce and in what quantities: food or arms, consumer goods or capital goods.
2. How to produce: labour-intensive or capital-intensive techniques.
3. For whom to produce: how the output is distributed between people.
4. Are resources fully and efficiently used?
5. Is the economy growing?

The problem is shown by the production possibility curve (PPC). Suppose an economy can produce the following combinations with all its resources:

Plotted with cloth on the horizontal axis and wheat on the vertical, the curve is concave to the origin because the opportunity cost of cloth rises (10, 15, 20, 25, 30 tonnes of wheat). A point inside the curve shows unemployed resources; a point outside is unattainable with present resources; an outward shift of the whole curve shows growth.

6. Economic statics, comparative statics and dynamics

The terms were borrowed from physics. J.B. Clark used them in economics; Ragnar Frisch and R.F. Harrod gave them precise meaning.

Economic statics studies a state of equilibrium at a point of time. All the variables relate to the same moment, and the analysis does not ask how the equilibrium was reached or what happens as time passes. Equilibrium price where demand equals supply is a static proposition. Clark compared it to a lake whose surface is still, although water is flowing in and out.

• Merits: simple; isolates the main forces; gives the end-point of an adjustment.
• Limits: assumes population, tastes, technique and resources unchanged; says nothing about the path or speed of adjustment, or whether equilibrium is ever reached.

Comparative statics compares two equilibrium positions, before and after a change in a datum, without studying the path between them. If demand increases, it compares the old equilibrium price and quantity with the new ones.

Economic dynamics studies the process of change over time. Frisch: a system is dynamic if its behaviour over time is determined by functional equations in which variables at different points of time are involved in an essential way. In other words, dynamics deals with time lags, rates of change and expectations. The standard micro example is the cobweb: farmers decide this year’s sowing on last year’s price, so a high price is followed by a glut and a low price, then by a shortage, and price oscillates around equilibrium.

• Merits: realistic; explains cycles, growth and the path of adjustment.
• Limits: mathematically difficult; depends on assumed lags and expectations, which are hard to measure.

How this is examined

In January 2026 (80-mark paper) Unit I offered a 6-mark note on “Problem of choice” or “Micro economics”; February 2025 (100-mark paper) set “Importance of micro economics” as a 10-mark part of Q.9. For the note, give Boulding’s definition, the scope, three or four uses and two limitations. For the problem of choice, state scarcity and alternative uses, list the central problems and describe the PPC with a small schedule like the one above.