Microeconomics

Microeconomics

Overview


Microeconomics is a branch of economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

 that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold. Microeconomics examines how these decisions and behaviours affect the supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

 for goods and services, which determines prices, and how prices, in turn, determine the quantity supplied and quantity demanded of goods and services.

This is in contrast to macroeconomics
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

, which involves the "sum total of economic activity, dealing with the issues of growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...

, inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

, and unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

." Microeconomics also deals with the effects of national economic policies (such as changing taxation levels) on the aforementioned aspects of the economy.
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Encyclopedia


Microeconomics is a branch of economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

 that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold. Microeconomics examines how these decisions and behaviours affect the supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

 for goods and services, which determines prices, and how prices, in turn, determine the quantity supplied and quantity demanded of goods and services.

This is in contrast to macroeconomics
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

, which involves the "sum total of economic activity, dealing with the issues of growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...

, inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

, and unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

." Microeconomics also deals with the effects of national economic policies (such as changing taxation levels) on the aforementioned aspects of the economy. Particularly in the wake of the Lucas critique
Lucas critique
The Lucas critique, named for Robert Lucas′ work on macroeconomic policymaking, argues that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.The basic idea...

, much of modern macroeconomic theory has been built upon 'microfoundations
Microfoundations
In economics, the term microfoundations refers to the microeconomic analysis of the behavior of individual agents such as households or firms that underpins a macroeconomic theory....

' — i.e. based upon basic assumptions about micro-level behavior.

One of the goals of microeconomics is to analyze market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...

 mechanisms that establish relative price
Relative price
A relative price is the price of a commodity such as a good or service in terms of another; i.e., the ratio of two prices. A relative price may be expressed in terms of a ratio between any two prices or the ratio between the price of one particular good and a weighted average of all other goods...

s amongst goods and services and allocation of limited resources amongst many alternative uses. Microeconomics analyzes market failure
Market failure
Market failure is a concept within economic theory wherein the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off...

, where markets fail to produce efficient results, and describes the theoretical conditions needed for perfect competition
Perfect competition
In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets...

. Significant fields of study in microeconomics include general equilibrium
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...

, markets under asymmetric information, choice under uncertainty
Uncertainty
Uncertainty is a term used in subtly different ways in a number of fields, including physics, philosophy, statistics, economics, finance, insurance, psychology, sociology, engineering, and information science...

 and economic applications of game theory
Game theory
Game theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...

. Also considered is the elasticity
Elasticity (economics)
In economics, elasticity is the measurement of how changing one economic variable affects others. For example:* "If I lower the price of my product, how much more will I sell?"* "If I raise the price, how much less will I sell?"...

 of products within the market system.

Assumptions and definitions


The theory of supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

 usually assumes that markets are perfectly competitive
Perfect competition
In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets...

. 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
Mainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...

 does not assume a priori
A priori and a posteriori (philosophy)
The terms a priori and a posteriori are used in philosophy to distinguish two types of knowledge, justifications or arguments...

that markets are preferable to other forms of social organization. In fact, much analysis is devoted to cases where so-called market failure
Market failure
Market failure is a concept within economic theory wherein the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off...

s lead to resource allocation
Resource allocation
Resource allocation is used to assign the available resources in an economic way. It is part of resource management. In project management, resource allocation is the scheduling of activities and the resources required by those activities while taking into consideration both the resource...

 that is suboptimal by some standard (defense spending is the classic example, profitable to all for use but not directly profitable for anyone to finance). In such cases, economist
Economist
An economist is a professional in the social science discipline of economics. The individual may also study, develop, and apply theories and concepts from economics and write about economic policy...

s may attempt to find policies that will 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 market
Missing market
A missing market is a situation in microeconomics where a competitive market allowing the exchange of a commodity would be Pareto-efficient, but no such market exists.-Examples:A variety of factors can lead to missing markets:...

s" to enable efficient trading where none had previously existed.

This is studied in the field of collective action
Collective action
Collective action is the pursuit of a goal or set of goals by more than one person. It is a term which has formulations and theories in many areas of the social sciences.-In sociology:...

 and public choice theory
Public choice theory
In economics, public choice theory is the use of modern economic tools to study problems that traditionally are in the province of political science...

. It also must be noted that "optimal welfare" usually takes on a Paretian
Pareto efficiency
Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...

 norm, which in its mathematical application of Kaldor–Hicks method. This can diverge from the Utilitarian
Utilitarianism
Utilitarianism is an ethical theory holding that the proper course of action is the one that maximizes the overall "happiness", by whatever means necessary. It is thus a form of consequentialism, meaning that the moral worth of an action is determined only by its resulting outcome, and that one can...

 goal of maximising 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 his or her 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 maximise their own utility. The interpretation of this relationship between price and quantity demanded of a given good assumes that, given all the other goods and constraints, the set of choices which emerges is that one which makes the consumer happiest.

Modes of operation


It is assumed that all firms are following rational decision-making, and will produce at the profit-maximizing output. Given this assumption, there are four categories in which a firm's profit may be considered to be.
  • A firm is said to be making an economic profit when its average total cost is less than the price of each additional product at the profit-maximizing output. The economic profit is equal to the quantity output multiplied by the difference between the average total cost and the price.
  • A firm is said to be making a normal profit when its economic profit equals zero. This occurs where average total cost equals price at the profit-maximizing output.
  • If the price is between average total cost and average variable cost at the profit-maximizing output, then the firm is said to be in a loss-minimizing condition. The firm should still continue to produce, however, since its loss would be larger if it were to stop producing. By continuing production, the firm can offset its variable cost and at least part of its fixed cost, but by stopping completely it would lose the entirety of its fixed cost
    Fixed cost
    In economics, fixed costs are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be time-related, such as salaries or rents being paid per month, and are often referred to as overhead costs...

    .
  • If the price is below average variable cost at the profit-maximizing output, the firm should go into shutdown
    Shutdown (economics)
    In economics, a firm will shutdown production when the revenue received from the sale of the goods or services produced cannot even cover the variable costs of production...

    . Losses are minimized by not producing at all, since any production would not generate returns significant enough to offset any fixed cost and part of the variable cost
    Variable cost
    Variable costs are expenses that change in proportion to the activity of a business. Variable cost is the sum of marginal costs over all units produced. It can also be considered normal costs. Fixed costs and variable costs make up the two components of total cost. Direct Costs, however,...

    . By not producing, the firm loses only its fixed cost. By losing this fixed cost the company faces a challenge. It must either exit the market or remain in the market and risk a complete loss.

Opportunity cost



Opportunity cost of an activity (or goods) is equal to the best next alternative foregone.
Although opportunity cost can be hard to quantify, the effect of opportunity cost is universal and very real on the individual level. In fact, this principle applies to all decisions, not just economic ones.
Since the work of the Austrian
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...

 economist Friedrich von Wieser
Friedrich von Wieser
Friedrich Freiherr von Wieser was an early member of the Austrian School of economics. Born in Vienna, the son of Privy Councillor Leopold von Wieser, a high official in the war ministry he first trained in sociology and law...

, opportunity cost has been seen as the foundation of the marginal theory of value.

Opportunity cost is one way to measure the cost of something. Rather than merely identifying and adding the costs of a project, one may also identify the next best alternative way to spend the same amount of money. The forgone profit of this next best alternative is the opportunity cost of the original choice. A common example is a farmer that chooses to farm her or his land rather than rent it to neighbors, wherein the opportunity cost is the forgone profit from renting. In this case, the farmer may expect to generate more profit alone. Similarly, the opportunity cost of attending university
University
A university is an institution of higher education and research, which grants academic degrees in a variety of subjects. A university is an organisation that provides both undergraduate education and postgraduate education...

 is the lost wages a student could have earned in the workforce, rather than the cost of tuition, books, and other requisite items (whose sum makes up the total cost of attendance). The opportunity cost of a vacation in the Bahamas might be the down payment for a house.

Note that opportunity cost is not the sum of the available alternatives, but rather the benefit of the single, best alternative. Possible opportunity costs of a city's decision to build a hospital on its vacant land are the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money that could have been made from selling the land, or the loss of any of the various other possible uses — but not all of these in aggregate. The true opportunity cost would be the forgone profit of the most lucrative of those listed.

One question that arises here is how to determine a money value for each alternative to facilitate comparison and assess opportunity cost, which may be more or less difficult depending on the things we are trying to compare. For example, many decisions involve environmental impacts whose monetary value is difficult to assess because of scientific uncertainty. Valuing a human life or the economic impact of an Arctic oil spill involves making subjective choices with ethical implications.

It is imperative to understand that nothing is free. No matter what one chooses to do, he or she is always giving something up in return. An example of opportunity cost is deciding between going to a concert and doing homework. If one decides to go the concert, then he or she is giving up valuable time to study, but if he or she chooses to do homework then the cost is giving up the concert. Opportunity cost is vital in understanding microeconomics and decisions that are made.

Applied microeconomics


Applied microeconomics includes a range of specialized areas of study, many of which draw on methods from other fields. Industrial organization
Industrial organization
Industrial organization is the field of economics that builds on the theory of the firm in examining the structure of, and boundaries between, firms and markets....

 examines topics such as the entry and exit of firms, innovation, and the role of trademarks. Labor economics examines wages, employment, and labor market dynamics. Public economics examines the design of government tax and expenditure policies and economic effects of these policies (e.g., social insurance programs). Political economy
Political economy
Political economy originally was the term for studying production, buying, and selling, and their relations with law, custom, and government, as well as with the distribution of national income and wealth, including through the budget process. Political economy originated in moral philosophy...

 examines the role of political institutions in determining policy outcomes. Health economics
Health economics
Health economics is a branch of economics concerned with issues related to efficiency, effectiveness, value and behavior in the production and consumption of health and health care...

 examines the organization of health care systems, including the role of the health care workforce and health insurance programs. Urban economics
Urban economics
Urban economics is broadly the economic study of urban areas; as such, it involves using the tools of economics to analyze urban issues such as crime, education, public transit, housing, and local government finance...

, which examines the challenges faced by cities, such as sprawl, air and water pollution, traffic congestion, and poverty, draws on the fields of urban geography and sociology. Financial economics
Financial economics
Financial Economics is the branch of economics concerned with "the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment"....

 examines topics such as the structure of optimal portfolios, the rate of return to capital, econometric analysis of security returns, and corporate financial behavior. Law and economics
Law and economics
The economic analysis of law is an analysis of law applying methods of economics. Economic concepts are used to explain the effects of laws, to assess which legal rules are economically efficient, and to predict which legal rules will be promulgated.-Relationship to other disciplines and...

 applies microeconomic principles to the selection and enforcement of competing legal regimes and their relative efficiencies. Economic history
Economic history
Economic history is the study of economies or economic phenomena in the past. Analysis in economic history is undertaken using a combination of historical methods, statistical methods and by applying economic theory to historical situations and institutions...

 examines the evolution of the economy and economic institutions, using methods and techniques from the fields of economics, history, geography, sociology, psychology, and political science.

Further reading

  • Bouman, John: Principles of Microeconomics - free fully comprehensive Principles of Microeconomics and Macroeconomics texts. Columbia, Maryland, 2011
  • Colander, David. Microeconomics. McGraw-Hill Paperback, 7th Edition: 2008.
  • Eaton, B. Curtis; Eaton, Diane F.; and Douglas W. Allen. Microeconomics. Prentice Hall, 5th Edition: 2002.
  • Frank, Robert A.; Microeconomics and Behavior. McGraw-Hill/Irwin, 6th Edition: 2006.
  • Friedman, Milton. Price Theory. Aldine Transaction: 1976
  • Hagendorf, Klaus: Labour Values and the Theory of the Firm. Part I: The Competitive Firm. Paris: EURODOS; 2009.
  • Harberger, Arnold C.
    Arnold Harberger
    Arnold C. Harberger is a United States economist. Harberger's Triangle, widely used in welfare economics, is named after him.-Life:...

    , 2008. "Microeconomics," The Concise Encyclopedia of Economics.
  • Hicks, John R. Value and Capital
    Value and Capital
    Value and Capital is a book by the British economist John Richard Hicks, published in 1939. It is considered a classic exposition of microeconomic theory...

    . Clarendon Press. [1939] 1946, 2nd ed.
  • Hirshleifer, Jack
    Jack Hirshleifer
    Jack Hirshleifer was an American economist and long-time professor at the University of California, Los Angeles....

    ., Glazer, Amihai, and Hirshleifer, David
    David Hirshleifer
    David Hirshleifer is a prominent American economist. He is a professor of finance and currently holds the Merage chair in Business Growth at the University of California at Irvine. He previously held tenured positions at the University of Michigan, The Ohio State University, and UCLA. His work...

    , Price theory and applications: Decisions, markets, and information. Cambridge University Press, 7th Edition: 2005.
  • Jehle, Geoffrey A.; and Philip J. Reny. Advanced Microeconomic Theory. Addison Wesley Paperback, 2nd Edition: 2000.
  • Katz, Michael L.; and Harvey S. Rosen. Microeconomics. McGraw-Hill/Irwin, 3rd Edition: 1997.
  • Kreps, David M. A Course in Microeconomic Theory. Princeton University Press: 1990
  • Landsburg, Steven. Price Theory and Applications. South-Western College Pub, 5th Edition: 2001.
  • Mankiw, N. Gregory. Principles of Microeconomics. South-Western Pub, 2nd Edition: 2000.
  • Mas-Colell, Andreu
    Andreu Mas-Colell
    Andreu Mas-Colell is a Spanish economist, an expert in microeconomics and one of the world's leading mathematical economists. He is the founder of the Barcelona Graduate School of Economics and a professor in the department of economics at Pompeu Fabra University in Barcelona, Catalonia, Spain...

    ; Whinston, Michael D.; and Jerry R. Green. Microeconomic Theory. Oxford University Press, US: 1995.
  • McGuigan, James R.; Moyer, R. Charles; and Frederick H. Harris. Managerial Economics: Applications, Strategy and Tactics. South-Western Educational Publishing, 9th Edition: 2001.
  • Nicholson, Walter. Microeconomic Theory: Basic Principles and Extensions. South-Western College Pub, 8th Edition: 2001.
  • Perloff, Jeffrey M. Microeconomics. Pearson - Addison Wesley, 4th Edition: 2007.
  • Perloff, Jeffrey M. Microeconomics: Theory and Applications with Calculus. Pearson - Addison Wesley, 1st Edition: 2007
  • Pindyck, Robert S.; and Daniel L. Rubinfeld. Microeconomics. Prentice Hall, 7th Edition: 2008.
  • Ruffin, Roy J.; and Paul R. Gregory. Principles of Microeconomics. Addison Wesley, 7th Edition: 2000.
  • Varian, Hal R.
    Hal Varian
    Hal Ronald Varian is an economist specializing in microeconomics and information economics. He is the Chief Economist at Google and he holds the title of emeritus professor at the University of California, Berkeley where he was founding dean of the School of Information...

     (1987). "microeconomics," The New Palgrave: A Dictionary of Economics, v. 3, pp. 461–63.
  • Varian, Hal R. Intermediate Microeconomics. & Company, 7th Edition.
  • Varian, Hal R. Microeconomic Analysis. W. W. Norton & Company, 3rd Edition.

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