MICROECONOMICS
Microeconomics (from Greek prefix mikro- meaning "small" + economics) is a branch of economics that studies the behavior of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms.[1][2][3]
One goal of microeconomics is to analyze the market mechanisms that establish relative prices among goods and services and allocate limited resources among alternative uses. Microeconomics shows conditions under which free markets lead to desirable allocations. It also analyzes market failure, where markets fail to produce efficient results.
While microeconomics focuses on firms and individuals, macroeconomics focuses on the sum total of economic activity, dealing with the issues of growth, inflation, and unemployment and with national policies relating to these issues.[2] Microeconomics also deals with the effects of economic policies (such as changing taxation levels) on microeconomic behavior and thus on the aforementioned aspects of the economy.[4] Particularly in the wake of the Lucas critique, much of modern macroeconomic theories has been built upon microfoundations—i.e. based upon basic assumptions about micro-level behavior.
What is Microeconomics?
Microeconomics is the social science that studies the implications of human action, specifically about how those decisions affect the utilization and distribution of scarce resources. Microeconomics shows how and why different goods have different values, how individuals make more efficient or more productive decisions, and how individuals best coordinate and cooperate with one another. Generally speaking, microeconomics is considered a more complete, advanced, and settled science than macroeconomics.
What is Microeconomics?
Understanding Microeconomics
Microeconomics is the study of economic tendencies, or what is likely to happen when individuals make certain choices or when the factors of production change. Individual actors are often grouped into microeconomic subgroups, such as buyers, sellers, and business owners. These groups create the supply and demand for resources, using money and interest rates as a pricing mechanism for coordination.
ΓKEY TAKEAWAYS
- Microeconomics studies the decisions of individuals and firms to allocate resources of production, exchange, and consumption.
- Microeconomics deals with prices and production in single markets and the interaction between different markets but leaves the study of economy-wide aggregates to macroeconomics.
- Microeconomists use mathematics as a language to formulate theories and observational studies to test their theories against the real-world performance of markets.
The uses of microeconomics
As a purely normative science, microeconomics does not try to explain what should happen in a market. Instead, microeconomics only explains what to expect if certain conditions change. If a manufacturer raises the prices of cars, microeconomics says consumers will tend to buy fewer than before. If a major copper mine collapses in South America, the price of copper will tend to increase, because supply is restricted. Microeconomics could help an investor see why Apple Inc. stock prices might fall if consumers buy fewer iPhones. Microeconomics could also explain why a higher minimum wage might force The Wendy's Company to hire fewer workers. Microeconomics can address questions like these that might have very broad implications for the economy; however, questions about aggregate economic numbers remain the purview of macroeconomics, such as what might happen to the gross domestic product (GDP) of China in 2020.
method of microeconomics
Most modern microeconomic study is performed according to general equilibrium theory, developed by L̩on Walras in Elements of Pure Economics (1874) and partial equilibrium theory, introduced by Alfred Marshall in Principles of Economics (1890). The Marshallian and Walrasian methods fall under the larger umbrella of neoclassical microeconomics. Neoclassical economics focuses on how consumers and producers make rational choices to maximize their economic well being, subject to the constraints of how much income and resources they have available. Neoclassical economists make simplifying assumptions about markets Рsuch as perfect knowledge, infinite numbers of buyers and sellers, homogeneous goods, or static variable relationships Рin order to construct mathematical models of economic behavior.
These methods attempt to represent human behavior in functional mathematical language, which allows economists to develop mathematically testable models of individual markets. As logical positivists, neoclassicals believe in constructing measurable hypotheses about economic events, then using empirical evidence to see which hypotheses work best. Unlike physicists or biologists, economists cannot run repeatable tests, so their empirical research depends on the collection and observation of economic data from real-world markets. The economic efficiency of markets is then determined by how well real markets adhere to the rules of the mode.
Basic concept of Microeconomics
The study of microeconomics involves several key concepts, including (but not limited to):
- Production theory: This is the study of production — or the process of converting inputs into outputs. Producers seek to choose the combination of inputs and methods of combining them that will minimize cost in order to maximize their profits.
- Utility theory: Analogous to production theory, consumers will choose to purchase and consume a combination of goods that will maximize their happiness or “utility”, subject to the constraint of how much income they have available to spend.
- Price theory: Production theory and utility theory interact to produce the theory of supply and demand, which determine prices in a competitive market. In a perfectly competitive market, it concludes that the price demanded by consumers is the same supplied by producers. That results in economic equilibrium.
- Industrial organization and market structure: Microeconomists study the many ways that markets can be structured, from perfect competition to monopolies, and the ways that production and prices will develop in these different types of markets.
Assumptions and definitions[edit]
Microeconomic theory typically begins with the study of a single rational and utility maximizing individual. To economists, rationality means an individual possesses stable preferences that are both complete and transitive.
The technical assumption that preference relations are continuous is needed to ensure the existence of a utility function. Although microeconomic theory can continue without this assumption, it would make comparative statics impossible since there is no guarantee that the resulting utility function would be differentiable.
Microeconomic theory progresses by defining a competitive budget set which is a subset of the consumption set. It is at this point that economists make the technical assumption that preferences are locally non-satiated. Without the assumption of LNS (local non-satiation) there is no 100% guarantee but there would be a rational rise in individual utility. With the necessary tools and assumptions in place the utility maximization problem (UMP) is developed.
The utility maximization problem is the heart of consumer theory. The utility maximization problem attempts to explain the action axiom by imposing rationality axioms on consumer preferences and then mathematically modeling and analyzing the consequences. The utility maximization problem serves not only as the mathematical foundation of consumer theory but as a metaphysical explanation of it as well. That is, the utility maximization problem is used by economists to not only explain what or how individuals make choices but why individuals make choices as well.
The utility maximization problem is a constrained optimization problem in which an individual seeks to maximize utility subject to a budget constraint. Economists use the extreme value theorem to guarantee that a solution to the utility maximization problem exists. That is, since the budget constraint is both bounded and closed, a solution to the utility maximization problem exists. Economists call the solution to the utility maximization problem a Walrasian demand function or correspondence.
The utility maximization problem has so far been developed by taking consumer tastes (i.e. consumer utility) as the primitive. However, an alternative way to develop microeconomic theory is by taking consumer choice as the primitive. This model of microeconomic theory is referred to as revealed preference theory.
The theory of supply and demand usually assumes that markets are perfectly competitive. This implies that there are many buyers and sellers in the market and none of them have the capacity to significantly influence prices of goods and services. In many real-life transactions, the assumption fails because some individual buyers or sellers have the ability to influence prices. Quite often, a sophisticated analysis is required to understand the demand-supply equation of a good model. However, the theory works well in situations meeting these assumptions.
Mainstream economics does not assume a priori that markets are preferable to other forms of social organization. In fact, much analysis is devoted to cases where market failures lead to resource allocation that is suboptimal and creates deadweight loss. A classic example of suboptimal resource allocation is that of a public good. In such cases, economists may attempt to find policies that avoid waste, either directly by government control, indirectly by regulation that induces market participants to act in a manner consistent with optimal welfare, or by creating "missing markets" to enable efficient trading where none had previously existed.
This is studied in the field of collective action and public choice theory. "Optimal welfare" usually takes on a Paretian norm, which is a mathematical application of the Kaldor–Hicks method. This can diverge from the Utilitarian goal of maximizing utility because it does not consider the distribution of goods between people. Market failure in positive economics (microeconomics) is limited in implications without mixing the belief of the economist and their theory.
The demand for various commodities by individuals is generally thought of as the outcome of a utility-maximizing process, with each individual trying to maximize their own utility under a budget constraint and a given consumption set.
Microeconomic theory[edit]
Consumer demand theory[edit]
Consumer demand theory relates preferences for the consumption of both goods and services to the consumption expenditures; ultimately, this relationship between preferences and consumption expenditures is used to relate preferences to consumer demand curves. The link between personal preferences, consumption and the demand curve is one of the most closely studied relations in economics. It is a way of analyzing how consumers may achieve equilibrium between preferences and expenditures by maximizing utility subject to consumer budget constraints.
Production theory[edit]
Production theory is the study of production, or the economic process of converting inputs into outputs.[5] Production uses resources to create a good or service that is suitable for use, gift-giving in a gift economy, or exchange in a market economy. This can include manufacturing, storing, shipping, and packaging. Some economists define production broadly as all economic activity other than consumption. They see every commercial activity other than the final purchase as some form of production.
Cost-of-production theory of value[edit]
The cost-of-production theory of value states that the price of an object or condition is determined by the sum of the cost of the resources that went into making it. The cost can comprise any of the factors of production (including labor, capital, or land) and taxation. Technology can be viewed either as a form of fixed capital (e.g. an industrial plant) or circulating capital (e.g. intermediate goods).
In the mathematical model for the cost of production, the short-run total cost is equal to fixed cost plus total variable cost. The fixed cost refers to the cost that is incurred regardless of how much the firm produces. The variable cost is a function of the quantity of an object being produced. The cost function can be used to characterize production through the duality theory in economics, developed mainly by Ronald Shephard (1953, 1970) and other scholars (Sickles & Zelenyuk, 2019, ch.2).
Opportunity cost[edit]
Opportunity cost is closely related to the idea of time constraints. One can do only one thing at a time, which means that, inevitably, one is always giving up other things. The opportunity cost of any activity is the value of the next-best alternative thing one may have done instead. Opportunity cost depends only on the value of the next-best alternative. It doesn't matter whether one has five alternatives or 5,000.
Opportunity costs can tell when not to do something as well as when to do something. For example, one may like waffles, but like chocolate even more. If someone offers only waffles, one would take it. But if offered waffles or chocolate, one would take the chocolate. The opportunity cost of eating waffles is sacrificing the chance to eat chocolate. Because the cost of not eating the chocolate is higher than the benefits of eating the waffles, it makes no sense to choose waffles. Of course, if one chooses chocolate, they are still faced with the opportunity cost of giving up having waffles. But one is willing to do that because the waffle's opportunity cost is lower than the benefits of the chocolate. Opportunity costs are unavoidable constraints on behaviour because one has to decide what's best and give up the next-best alternative.
Scopes of Microeconomics
The scope or the subject matter of microeconomics is concerned with:
Commodity pricing
The price of an individual commodity is determined by the market forces of demand and supply. Microeconomics is concerned with demand analysis i.e. individual consumer behavior, and supply analysis i.e. individual producer behavior.
Factor pricing theory
Microeconomics helps in determining the factor prices for land, labor, capital, and entrepreneurship in the form of rent, wage, interest, and profit respectively. Land, labor, capital, and entrepreneurship are the factors that contribute to the production process.
Theory of economic welfare
Welfare economics in microeconomics is concerned with solving the problems in improvement and attaining economic efficiency to maximize public welfare. It attempts to gain efficiency in production, consumption/distribution to attain overall efficiency and provides answers for ‘What to produce?’, ‘When to produce?’, ‘How to produce?’, and ‘For whom it is to be produced?’
Microeconomic models[edit]
Supply and demand[edit]
Supply and demand is an economic model of price determination in a perfectly competitive market. It concludes that in a perfectly competitive market with no externalities, per unit taxes, or price controls, the unit price for a particular good is the price at which the quantity demanded by consumers equals the quantity supplied by producers. This price results in a stable economic equilibrium.
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