Report: Impact of Microeconomic Theories on Small Business Operations

This report delves into the application of microeconomic theories within the context of small business operations. It begins with an introduction to the fundamental principles of microeconomics, emphasizing their importance in effective business management. The core of the report examines several key theories, including the theory of production and cost, which explores factors of production, cost functions (fixed, variable, average, and marginal), and their impact on profit. The theory of demand and supply is then discussed, focusing on demand schedules, the law of demand and supply, and shifts in demand and supply curves. Next, the report explores the theory of market structure, differentiating between various market types such as monopolistic competition, oligopoly, monopoly, and perfect competition. The production possibility theory, which helps firms measure the maximum level of output, is also analyzed. The report concludes by highlighting the practical implications of these microeconomic theories for small businesses, emphasizing how they can guide decision-making and contribute to overall business success.

ECONOMICS FOR MANAGERS

Contents
INTRODUCTION...........................................................................................................................3
MICROECONOMIC THEORIES IMPACTING BUSINESS.......................................................4
THEORY OF PRODUCTION AND COST................................................................................4
THEORY OF DEMAND AND SUPPLY...................................................................................7
THEORY OF MARKET STRUCTURE.....................................................................................9
PRODUCTION POSSIBILITY THEORY................................................................................11
MICROECONOMIC THEORIES AND SMALL BUSINESS....................................................12
CONCLUSION..............................................................................................................................13
REFERENCES..............................................................................................................................14

INTRODUCTION
There are numerous activities that has to be carried out for managing and running a business in
an efficient manner. One should have proper knowledge of the various theories for running the
operations of the business smoothly and successfully. There are many theories existing but the
most important is the micro economic theories relating production, cost, demand, supply, market
structure, etc. The objective of preparing this report is to know the impact of such theories on a
small business firm. The branch of economics that takes into consideration the behavior of
decision makers present in the economy. As the word ‘Microeconomics’ suggest, it focuses on
small or micro level segments of the firm and it gives an idea of how to use the limited resources
in an optimum manner (Alex, 2012).

MICROECONOMIC THEORIES IMPACTING BUSINESS
There are certain theories that a owner of a small business firm must take into account while
carrying out business operations. Such theories include- theory of production and cost, theory of
demand and supply, theory of market structure, Production possibility theory. All these theories
are discussed in details in this report.
THEORY OF PRODUCTION AND COST
Production is the activity which helps a business enterprise to gain market share and start earning
profits. There are two factors that are associated with the production of goods and services.
These factors are production factors and cost factors. Let us discuss both of them in detail. The
two most important production functions are labor and capital. A product or service can be
produced when both these factors combine (Berman, Knight, & Case, 2013). A production
function can be called efficient when it is able to produce larger quantities of products with the
minimum resources that are available without compromising with the quality of the product.
Based on the cost function, a firm should aim at cost reduction as it would directly have a
favorable impact on the profits. There are various costs which need to be taken into
consideration while producing a product.
The production function defines the relationship between the inputs and the outputs. Although
there are various factors of production but we will take into consideration capital and labor. The
volume output that is produced by a firm depends majorly on these two factors. In the short run,
capital is considered to be the fixed factor whereas labor is the variable component. Both capital
and labor is variable in the long run (Berman, Knight, Case, & Berman, 2008). Also, factor
substitution can be done in the long run i.e. increase or decrease capital and labor as per
requirement.
In the cost function, there are two categories of cost – Fixed cost and Variable cost. In the short
run, either of the factors of production is fixed and therefore, the firm has to suffer both fixed and
variable costs. Fixed costs can be defined as those costs which do not differ at different levels of
production and is incurred even when there is production activity ongoing. Variable costs differ
with the units of production and over a period of time. The total cost of a product includes both
variable cost and fixed cost.

Now let us understand the concept of average total cost, average variable cost and marginal cost.
Average total cost can be defined as the average price of each unit, It is calculated by dividing
the total cost by Quantity produced. Marginal cost is the cost incurred for producing one
additional unit. It is generally U shaped because the cost increases with the level of production.
Average variable cost can be defined as variable cost per unit. It is calculated by dividing total
variable cost by number of units produce (Cafferky, & Wentworth, 2010).

The above diagram shows that if the marginal cost is less than the average variable cost, then it is
observed that the average cost falls whereas if marginal cost exceeds the average variable cost
then the average cost rises. However, if marginal cost is equal to the average variable cost then
average cost is said to be at minimum (Fischer, Cheng, & Taylor, 2002).

THEORY OF DEMAND AND SUPPLY
Demand for a commodity can be justified as the quantity of a particular commodity or good that
a consumer is willing to purchase at a fixed rate at a particular point of time. Demand is
generally actuated in accordance with the demand of the entire market or an individual. The
demand for a product generally depends on the price of the commodity, price of the related
commodities, the income of the consumers, size of the population and various other factors. The
functional relationship present between the factors affecting the demand and the quantity
demanded that a particular product is mentioned as demand function (Garrison, & Noreen,
2003). In order to understand the demand function properly, a tabular statement which displays
the number of various commodities at different price levels during a specified period of time is
made and is called demand schedule.
The law of demand states that there exists an inverse relationship between the price and quantity
demanded of a product keeping other factors constant (Goyal, 2012). This law is also generally
known as the “First Law of Purchase”. The law of demand is qualitative and not quantitative in
nature because it indicates the magnitude of the changes and not the direction of the amount

demanded. Also, there is no proportionality present between the price and quantity demanded of
a particular product.
The supply of a commodity can be justified as the total quantity of a particular product that a
manufacturer is able to offer to its customer for sale in a particular period of time. The supply of
a particular product depends on various factors like the cost of the commodity, cost of
production, government policies, price of related goods, etc. The Law of Supply declares that
there exists a direct relationship present between the price of a particular product and the
quantity supplied when all other factors are kept constant (Hoyle, 2015). Price is the determining
factor for aggregating the supply of a particular product. Hence, an increase in the price of the
product will decrease the supply and vice-versa. Also, the behavior of the producers is studied
under the law of supply. The law of supply displays a positive relationship that is present
between the price and the quantity supplied of a particular product. The law is also one-sided in
nature because it explains the effect of the change in the price because of the supply but not the
effect of change of supply on the price (Narayanaswamy, 2014).
A shift in the demand or supply curve refers to the change in the quantity demanded or supplies
of a particular product, price remaining constant. It can be understood clearly with the help of an
example where a bottle is being sold for $3 in a particular time period but a change is quantity
demanded is noticed when it increases from Q1 to Q2. This change in quantity can be termed as

the shift in demand for the bottle. These changes in the curves clearly represents that the original
relationship of the demand have changes.

THEORY OF MARKET STRUCTURE
The market can be explained as a particular place where the buyers and sellers meet in order to
carry out business. The term market structure can be referred to as the nature and the degree of
the competitions that take place in the market for the goods and the services. It is very important
for businesses to determine the conditions of the market before entering the industry. There are
various factors that determine the market structure like the number of sellers, the nature of the
products, the economies of scale, etc. There are four types of market structures which are a
monopoly, oligopoly, monopolistic competition, and perfect competition. There are various
patterns and trends which determine the nature of the market structure (Pandey, 2015).
A monopolistic competitive market is a type of market in which there are various sellers and all
are selling the same product that is differentiated with the help of branding of quality (Not
perfect substitutes). In this type of market, the organizations are the price makers. The sellers
constantly try to differentiate between each other.
Oligopoly can be mentioned as a market place where there are various small firms that function
exercise control over the whole market place. There are different types of market places like a
duopoly, monopsony, and oligopsony.
A monopoly is a market condition where there is only one provider of a product and service in
the whole market. A natural monopoly is observed to occur when the economies of scale help the
firm to attain total control over the market place. The size of the organizations constantly
increases in monopoly. The organization tries to provide the goods and services to the customers
at a low price in order to meet the demand. A monopoly is very hard to exercise because of the
constant increase in competition in the industries.

A perfectly competitive market can be defined as a market place where there are a lot of buyers
and sellers present. All the sellers and buyers are well informed of the market structure and any
scope of monopoly is absent. The market price of the product cannot be controlled by the
individual buyers and sellers of the market. There are low barriers for entering such market
places and they have a perfectly elastic demand curve.

PRODUCTION POSSIBILITY THEORY
A production possibility theory helps a firm to measure the maximum level of output that can be
attained using the limited amount of input. This theory assumes that if the production of
commodity A increases then the production for commodity B will surely fall. It is also known as
production possibility frontier. It shows the tradeoff between the production level of two
different products.
The production possibility curve usually bows outward. All the points that lying on the curve
shows that there is production efficiency for both the products. Any point that falls inside the
curve shows that an economy is not carrying out production at its comparative advantage. If the
point lies outside the curve then it is impossible to produce these goods because there is not
enough resources (Pratt, 2006). Any economic leader will desire that the production possibility
curve moves outwards and towards the right.
We can conclude that a production possibility frontier shows the right combination of products
that can be produced using the limited resources available. This level of production that is
determined thriugh this frontier would help the firm to gain maximum profits.

MICROECONOMIC THEORIES AND SMALL BUSINESS.
It is very important for small businesses to identify the target market for the product selling and
distribution. It is very difficult for any business to enter into the oligopoly market structure or
monopoly market structure right away because there is huge involvement of class. Usually, it is
observed that a small business operates in a monopolistic or a perfectly competitive market.
Small business firms can never be the price makers and they earn normal profits. The price that
has been determined by the market forces is charged by them. Such business firms are
considered to be productive and efficient when they carry out their operation in the perfectly
competitive market. It is easy for such firms to exit from the market but if the firms are
operating in monopoly or oligopoly market then exit becomes difficult. It has been observed
from the past experiences that the owner of small business finds these microeconomic theories
very beneficial. So, every person who is operating a business should adhere to these theories so
that they can take their decisions correctly.

CONCLUSION
From this report we can conclude that it is important to know about these theories to carry out
operations in a small business firm. These theories help the management of the company to take
decisions in an appropriate manner. There are various activities that are involved in carrying out
business operations starting from production to selling and distribution. The above theories
define the market structure in which the business should operate, the availability of factors of
production, demand and supply, optimum production level etc. So, it can be concluded that
these theories are very impactful on the small business firm.

REFERENCES
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Cafferky, M., & Wentworth, J. (2010). Breakeven analysis (1st ed.). New York: Business Expert
Press.
Fischer, P., Cheng, R., & Taylor, W. (2002). Advanced accounting (1st ed.). Mason: South-
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Garrison, R., & Noreen, E. (2003). Managerial accounting (1st ed.). Boston: Irwin/McGraw-
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Narayanaswamy, R. (2014). Financial accounting (1st ed.). [Place of publication not identified]:
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Pandey, I. (2015). Financial management (1st ed.). New Delhi: Vikas Publishing House PVT
LTD.
Pratt, J. (2006). Financial accounting in an economic context (1st ed.). Hoboken, NJ: John Wiley
& Sons.