Microeconomic factors

Q: What is the basic economic problem, and why does it occur?

The basic economic problem is scarcity , which arises because society has infinite wants but only finite resources.

Q: How is opportunity cost defined in economic decision-making?

Opportunity cost is the cost of the next best alternative forgone when a choice is made.

Q: What does the Law of Demand state about the relationship between price and quantity demanded?

Assuming other factors remain unchanged ( ceteris paribus ), as the price of a good rises, the quantity demanded falls, resulting in a downward-sloping demand curve.

Business and Technology (BT) · ACCA · 8 min read · Updated: Nov 3, 2026

Introduction to Microeconomics

Welcome! In this chapter, we are zooming in on the "Micro" side of economics. While Macroeconomics looks at the whole economy (like national income, inflation, and fiscal policy), Microeconomics focuses on individual consumers, markets, and businesses. Understanding how prices are determined, how costs behave, and how firms compete is fundamental for business and accounting professionals.

1. The Basic Economic Problem

At its heart, economics exists because of Scarcity.
Society has infinite wants, but resources (land, labour, capital, and enterprise) are finite. Because not every want can be satisfied, choices must be made.

Opportunity Cost

Every time a choice is made, an alternative is forgone. Opportunity Cost is the cost of the next best alternative forgone.
Example: If a company spends \$10,000 on a marketing campaign, the opportunity cost is what could have been achieved by spending that \$10,000 on upgrading office computers instead.

The Three Fundamental Questions

Because of resource scarcity, economic systems must resolve:
1. What to produce?
2. How to produce it?
3. For whom to produce it?

2. Demand and Supply

In a market economy, prices and output levels are determined through the interaction of Demand and Supply.

The Law of Demand

Other things being equal (ceteris paribus), as the Price of a good rises, the Quantity Demanded falls, leading to a downward-sloping demand curve.
Analogy: If a coffee shop doubles the price of a latte, most customers will cut down on how often they buy lattes.

Factors that Shift the Demand Curve:
A change in price causes a movement along the curve, but changes in other conditions shift the entire curve:
• Income: For normal goods, demand rises as consumer income rises; for inferior goods, demand falls.
• Tastes and Preferences: Fashion and consumer trends alter demand.
• Price of Substitutes: If the price of an alternative product rises, demand for this product increases.
• Price of Complements: If the price of a related good rises (e.g. video game consoles), demand for complementary goods (games) falls.
• Population and Demographics: Changes in population size or age profile shift demand.

The Law of Supply

As the Price of a good rises, businesses are normally willing to Supply more because higher prices offer higher potential profitability, leading to an upward-sloping supply curve.

Factors that Shift the Supply Curve:
• Costs of Production: Higher wages, raw materials, or energy costs decrease supply (shifting the curve left).
• Technological Advances: Better production techniques increase efficiency and expand supply (shifting the curve right).
• Taxes and Subsidies: Indirect taxes increase costs and reduce supply, whereas government subsidies increase supply.
• External Shocks: Weather conditions, natural disasters, or supply chain bottlenecks directly affect output.

Market Equilibrium

The Equilibrium Price (or market clearing price) occurs where Quantity Demanded equals Quantity Supplied.
• If the market price is set above equilibrium, supply exceeds demand, creating an excess supply (surplus), which puts downward pressure on price.
• If the market price is set below equilibrium, demand exceeds supply, creating an excess demand (shortage), which puts upward pressure on price.

3. Elasticity of Demand

Elasticity measures the responsiveness of quantity demanded to changes in price, income, or related goods' prices.

Price Elasticity of Demand (PED)

PED measures the responsiveness of the quantity demanded of a good to a change in its price:
$ PED = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in price}} $

• Inelastic Demand ($|PED| < 1$): The percentage change in quantity demanded is smaller than the percentage change in price. Consumers are relatively insensitive to price changes (e.g. necessities or goods with few substitutes). An increase in price leads to an increase in total revenue.
• Elastic Demand ($|PED| > 1$): The percentage change in quantity demanded is larger than the percentage change in price. Consumers are sensitive to price changes (e.g. luxury items or goods with close substitutes). An increase in price leads to a fall in total revenue.
• Unit Elastic Demand ($|PED| = 1$): The percentage change in quantity demanded exactly matches the percentage change in price; total revenue remains unchanged.

Substitutes and Complements

• Substitutes: Alternative goods that satisfy the same need. Cross Price Elasticity of Demand (XED) between substitutes is positive: when the price of Good B rises, demand for Good A rises.
• Complements: Goods consumed together. XED between complementary goods is negative: when the price of Good B rises, demand for Good A falls.

4. Short-Run and Long-Run Cost Behaviour

Understanding cost behaviour over different time horizons is essential for managerial decision-making, pricing, and output determination.

Short-Run Cost Behaviour

In economics, the short run is a time horizon in which at least one factor of production is fixed (usually capital, factory space, or plant equipment), while other factors (like raw materials and labour) are variable.

• Fixed Costs (FC): Costs that do not vary with the level of output in the short run (e.g. factory rent, depreciation of plant, business rates). Average Fixed Cost (AFC) declines continuously as output rises, because fixed overheads are spread over more units.
• Variable Costs (VC): Costs that change directly with changes in output (e.g. direct materials, hourly wages, piece-rate labour).
• Total Cost (TC): The sum of total fixed costs and total variable costs: $ TC = FC + VC $.
• Marginal Cost (MC): The additional cost incurred from producing one extra unit of output: $ MC = \frac{\Delta TC}{\Delta Q} $.
• Law of Diminishing Returns: In the short run, as successive units of a variable input (such as workers) are added to a fixed input (such as machines), a point is eventually reached where the additions to total output (marginal product) begin to diminish. Because additional workers contribute less extra output, the marginal cost of producing extra units begins to rise, giving short-run marginal cost and average cost curves their characteristic U-shape.

Long-Run Cost Behaviour

In the long run, all factors of production are variable. A business can alter its factory size, purchase new facilities, adopt new technologies, or exit the industry entirely.

• Economies of Scale: As a firm increases the scale of production in the long run, its long-run average cost (LRAC) falls. Sources include:
- Technical economies: Specialised, large-scale machinery and automation.
- Purchasing/commercial economies: Bulk-buying discounts for raw materials.
- Financial economies: Lower interest rates and easier access to capital markets for large corporations.
- Managerial economies: Ability to employ specialist managers in marketing, HR, finance, and operations.
• Diseconomies of Scale: If a firm expands beyond its optimal size, long-run average costs begin to increase. This often arises from communication breakdowns, coordination difficulties, red tape, and poor employee morale across huge organisations.

5. Market Structures

Firms operate in various market structures that dictate their pricing power, barriers to entry, and competitive strategy.

1. Perfect Competition

A theoretical benchmark of extreme competition:
• Number of firms: Very large number of small buyers and sellers.
• Product type: Homogeneous (identical goods).
• Barriers to entry/exit: None; completely free entry and exit.
• Pricing power: Firms are Price Takers. Market demand and supply set the equilibrium price; an individual firm faces a horizontal demand curve.
• Information: Perfect knowledge amongst all buyers and sellers.

2. Monopoly

The opposite extreme, where the market consists of a single producer:
• Number of firms: One sole supplier dominating the market.
• Product type: Unique product with no close substitutes.
• Barriers to entry: Extremely high or insurmountable barriers (e.g. patents, legal licenses, immense capital requirements, natural monopolies).
• Pricing power: The firm is a Price Maker, facing a downward-sloping demand curve, though constrained by consumer willingness to pay.

3. Oligopoly

A market dominated by a few large, powerful enterprises:
• Number of firms: A few large firms account for the majority of market share.
• Product type: Can be homogeneous (e.g. oil, steel) or differentiated (e.g. smartphones, automobiles, banking).
• Barriers to entry: High barriers to entry (economies of scale, brand loyalty, significant capital investment).
• Interdependence: The actions of one firm directly impact competitors. Pricing or output decisions prompt retaliatory moves, which can result in collusive agreements or intense non-price competition (branding, advertising, loyalty programmes).

4. Monopolistic Competition

A blend of competitive forces and branding power:
• Number of firms: Many buyers and many sellers.
• Product type: Differentiated products (goods or services differ by design, brand image, customer service, or quality).
• Barriers to entry: Low barriers to entry and exit.
• Pricing power: Firms have some degree of price-setting discretion because customers view their brand as slightly different, resulting in a downward-sloping demand curve.

Summary: Market Structure Characteristics

• Perfect Competition: Many sellers, identical products, zero barriers, price taker.
• Monopolistic Competition: Many sellers, differentiated products, low barriers, slight pricing power.
• Oligopoly: Few large sellers, high barriers, mutual interdependence.
• Monopoly: Single seller, unique product, high barriers, price maker.

Final Quick Review

• Scarcity and Opportunity Cost: Limited resources require choices; opportunity cost is the next best alternative forgone.
• Demand and Supply: Market clearing equilibrium is achieved where quantity demanded equals quantity supplied.
• Elasticity: PED reveals sensitivity to price; positive XED signifies substitutes, while negative XED signifies complements.
• Cost Behaviour: In the short run, at least one factor is fixed and diminishing returns occur; in the long run, all inputs are variable and firms experience economies or diseconomies of scale.
• Market Structures: Ranging from perfect competition (price takers) to monopoly (price makers), dictating competitive behavior and profitability.

References

ACCA Business and Technology (BT/FBT) Syllabus and Study Guide — ACCA

Quick check

Can you answer these now?

Open each question to check the key ideas from this chapter.

What is the basic economic problem, and why does it occur?

The basic economic problem is scarcity, which arises because society has infinite wants but only finite resources.

How is opportunity cost defined in economic decision-making?

Opportunity cost is the cost of the next best alternative forgone when a choice is made.

What does the Law of Demand state about the relationship between price and quantity demanded?

Assuming other factors remain unchanged (ceteris paribus), as the price of a good rises, the quantity demanded falls, resulting in a downward-sloping demand curve.

What does the Law of Supply state, and how do production costs affect supply?

The Law of Supply states that as price rises, quantity supplied increases; an increase in production costs reduces profitability, shifting the supply curve to the left.

How is market equilibrium determined, and what occurs when price deviates from it?

Market equilibrium occurs where quantity demanded equals quantity supplied; prices set above create a surplus, while prices below create a shortage.

How is Price Elasticity of Demand (PED) calculated and interpreted regarding price changes and total revenue?

ewline$ PED = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in price}} $; demand is inelastic when $ |PED| < 1 $ (price rise increases revenue) and elastic when $ |PED| > 1 $ (price rise reduces revenue).

How does Cross Price Elasticity of Demand (XED) distinguish between substitute goods and complementary goods?

Cross Price Elasticity of Demand is positive for substitute goods and negative for complementary goods.

What distinguishes the short run from the long run in economics?

In the short run, at least one factor of production is fixed, whereas in the long run, all factors of production are variable.

What is the Law of Diminishing Returns, and how does it influence short-run costs?

The Law of Diminishing Returns states that adding successive units of a variable input to a fixed input eventually yields diminishing additions to output, causing marginal cost to rise.

What is the difference between economies of scale and diseconomies of scale in the long run?

Economies of scale lead to falling long-run average costs as output expands, whereas diseconomies of scale cause long-run average costs to rise due to inefficiency at excessive scales.

What are the key market characteristics that define perfect competition?

Perfect competition features a very large number of small buyers and sellers, homogeneous products, zero barriers to entry, perfect information, and firms acting as price takers.

What defines a monopoly, and what is its primary source of market power?

A monopoly is a market with a single supplier selling a unique product without close substitutes, protected by extremely high barriers to entry that make it a price maker.

What is the defining characteristic of an oligopoly regarding competitors' actions?

The defining characteristic of an oligopoly is interdependence, where the pricing and output decisions of a few dominant firms directly impact and provoke reactions from competitors.

How does monopolistic competition combine elements of both competitive markets and monopolies?

It features many buyers and sellers with low barriers to entry like perfect competition, but firms sell differentiated products, giving them slight price-setting power like a monopoly.

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