Microeconomics

Microeconomics, study of the economics of small units: individual companies, small groups of consumers, and so on. Economics has been defined as the study of the allocation of scarce means among competing ends. That is to say, humans are assumed to have a variety of objectives, ranging from the satisfaction of such minimum needs as food, clothing, and shelter, to more complex objectives of all kinds, material, aesthetic, and spiritual. However, the means available to satisfy these objectives at any point in time are limited by the available supply of factors of production (labour, capital, and raw materials) and the existing technology. Microeconomics is basically the study of how these resources are allocated to the satisfaction of the competing objectives. It contrasts with macroeconomics, which is concerned with the extent to which the available resources are fully utilized, or increase over time, and related issues. But it is not always possible to draw a sharp dividing line between microeconomics and macroeconomics. For example, it is often believed that much of the difference between conflicting schools of thought in macroeconomics can be traced back to differences in assumptions of a microeconomic character. This would be the case, for example, if different views of the role played by the interest rate in regulating overall economic activity—which is a macroeconomic topic—reflected different views of the motivations behind peoples’ demand for money, which falls within the domain of microeconomics.

The central concepts of microeconomics are those used to describe (1) the way individuals or households form their demands for different goods and services; (2) the way firms decide which, and how many, goods or services they will supply, and what combination of factors of production they should employ in the course of production; (3) the way that markets enable these supplies and demands to interact. These three components of microeconomics can be summarized, therefore, as demand, supply, and market equilibrium. Important subsections of microeconomic theory include welfare economics and public finance.

Key concepts that are used in the analysis of demand, supply, and market equilibrium are the concepts of rational choice and optimality. Basic microeconomics builds on certain simplifying assumptions concerning the behaviour of economic agents, which are known to be only partially valid, but which are believed to be sufficiently applicable to enable usefully precise predictions to be made about the way that consumers and producers behave. For example, the theory of consumers’ demand assumes that consumers are “rational” in that they want to maximize utility (abstracting here from the question of what exactly is meant by “utility” and how far it corresponds to an individual’s “welfare”). Optimal choice for a consumer, therefore, is that choice among the options available to him (for the sake of brevity we shall assume that the consumer is masculine) that will enable him to maximize his utility. The options available to him are basically those determined by his purchasing power (a function of his income and his access to capital, including credit), and the prices of the goods and services available. Given the information available to him concerning these options, his utility-maximizing choice will depend on his preference patterns—that is, his subjective ranking of the extent to which different combinations of goods and services will affect the total utility.

The microeconomic theory of consumers’ demand, therefore, is designed to demonstrate, on the basis of the minimum acceptable psychological assumptions, how a consumer’s utility-maximizing choice will be affected by changes in any of these determinants—that is, in his purchasing power, the prices of the goods and services available, and his preference patterns. For example, the theory enables us to make useful predictions of the extent to which certain characteristics of different goods or of the situation of the consumer will determine the sensitivity of demand to changes in the price of any product or of other goods that are related to it. The explanation of the determinants and properties of different demand schedules are typical of the theoretical deductions that can be made on the basis of very simple assumptions concerning consumer behaviour. The elementary theory also explains certain paradoxical phenomena, such as why, in some cases, demand is not inversely correlated with relative price, or why diamonds, which are far less important in life than water, are usually far more expensive.

The individual is, of course, not assumed to be simply a consumer. In order to acquire purchasing power in the form of income he must sell his labour. One basic choice that he has to make, therefore, is between income, on the one hand, and leisure, on the other hand. Again, he can be shown to be chosing optimally when the ratio of the marginal utility of income and leisure is equal to the relative price—that is, the wage. The theory will explain, for example, why a rise in wages will sometimes induce an increase in the supply of labour and sometimes induce a decrease. Similarly, the consumer has to chose between consumption at different points of time. For by abstaining from consumption in any time period in order to invest he has the opportunity of consuming more at a later period. This would be covered by the microeconomic theory of intertemporal choice. Intertemporal choice also introduces the question of risk, for one factor that the consumer will take into account in saving and consumption decisions, as in all other decisions, is the risk involved. Part of microeconomic theory, therefore, deals with optimal choice under conditions of uncertainty, which has links with game theory and has obvious applications, for example, as regards insurance policies.

The theory of demand, whilst very sophisticated in its higher reaches, is rather more satisfactory and applicable than the theory of supply. The latter attempts to explain the behaviour of economic agents acting in their capacity of producers, notably when acting as “firms”, a topic which requires the discrete discipline of the theory of the firm. Here, the basic assumption—corresponding to the assumption of demand theory to the effect that consumers are attempting to maximize utility—would be that firms attempt to maximize profits. But this simplifying assumption would be far less widely applicable than its demand theory counterpart. This is partly because firms are controlled by managers whose objectives may not be limited to the maximization of the firms’ profits. Managers may be motivated by other considerations, such as their own salaries and bonuses, and their power and prestige. These may depend on the firm’s size and acquisitions as much as on the profitability of its operations, though, in the longer term, the potential power of shareholders may induce firms to conform to some long-term profit-maximization model.

Even assuming a simple profit-maximization model for the firm, however, there are still many obstacles to the derivation of a simple model of the determination of supply of any commodity. In the short run, and given capacity, the profit-maximization assumption leads to fairly clear predictions concerning the scale of a firm’s output and the way the firm would employ different factors of production, at least under conditions of perfect competition. Reasonable assumptions can be made as to the general relationship between changes in inputs of factors of production and the resulting changes in output. These technological assumptions, embodied in “production functions”, correspond to the assumptions made in demand theory concerning the relationship between consumption of any good and its marginal utility to the consumer. Given some general assumptions concerning the nature of production functions, various propositions can be derived concerning the way that average costs and marginal costs vary with output and hence the most profitable level of output of any commodity, and the most profitable combination of factors of production.

Hence, short-term supply schedules, which would be the counterpart of the demand schedules described above, do not raise too many difficult problems. The supply theory also provides a sound basis for short-term predictions concerning the way that firms will vary their demand for factors of production in response to changes in their relative prices. At the same time there is a considerable body of theory concerning the way that firms will bargain with their employees, and the extent to which their employment practices are motivated by simple considerations of relative wages rather than by more sophisticated concerns with employees’ morale, or with the extent to which on-the-job training has added to the value of the existing labour force. Such theories, including “insider-outsider” theory, helps explain why, for example, unemployed labour does not usually succeed—except perhaps in the most unskilled occupations—in inducing firms to hire them at a lower wage if this means firing some of the existing employees. This is another example of the microeconomic foundations of some topics in macroeconomics.

Whilst the foundations of short-term supply schedules are fairly soundly based and can provide reliable explanations and predictions of short-run behaviour by firms, explanations of the longer-term supply schedules are less soundly based. This is because of the scope for varying productive capacity, the difficulty of making sound assumptions concerning economies of scale and technological change, and the arbitrariness of the time period selected once one goes beyond the period in which capacity is assumed to be more or less fixed (not that this concept is as clear-cut as may seem at first sight). By putting together the demand schedules from consumer theory with the supply schedules derived from the theory of the firm, it is possible to construct models of how markets operate. For the reason given above such models may—in spite of their simplifying assumptions—give very good predictions of the short-term reaction of supply and demand to changes in any of the underlying determinants of these two schedules. This branch of theory is known as “comparative statics”. Thus, for example, fairly confident and precise predictions can be made of the effect of any change in consumers’ preferences or in technology, on the resulting changes in demand, supply, and equilibrium output, but only under conditions of perfect competition.

Whilst the model of the firm under conditions of perfect competition is the starting point of the theory of supply in microeconomics, it is generally accepted that markets are not usually characterized by perfect competition, but by imperfect competition of one form or another. In some cases this may be more or less complete monopoly, where only one producer supplies the whole market. In others the market may be an oligopoly—dominated by a handful of major suppliers. And yet others may exhibit the characteristics of imperfect competition whilst not being dominated by one or a few suppliers. This would be the case, for example, in a market in which it is impossible for consumers to be well informed of the prices and qualities that are offered by competing sellers. For, in principle, perfect competition requires that all buyers are aware of all the prices that competing sellers are proposing. Clearly such information is never available except, perhaps, in very basic local markets. Consumers may also be attached to specific suppliers on account of influences such as proximity, habit, reliability, quality, and other determinants of consumer loyalty, thereby creating an imperfect market in the product in question or the sales outlet in question.

The third major component of microeconomic theory, therefore, namely the theory of the way that markets operate to bring about an equilibrium between demand and supply, is concerned with the operation of markets under different degrees of competition. This is not too difficult in the case of pure monopoly, but such cases are rare. For example, the supply of electricity in any region is usually provided by a single monopoly supplier. But there is usually always some threat of competition from different sources of energy—such as gas or oil—that can impose some constraint on the profit-maximization behaviour of a monopolist, particularly in the longer term. Where there are a few major suppliers of a market—where conditions of oligopoly prevail—the theory moves into the realm of game theory.

Needless to say, microeconomics provides the foundations for almost any particular branch of economics. For example, the analysis of the effect of imposing any tax, in the theory of public finance, must depend on microeconomic models to show how it will affect supply, demand, and price, and hence determine the revenue that the tax may generate, or how it will affect the supply of factors of production. For example, an income tax might discourage the supply of labour and a profits tax might discourage the level of investment. Similarly, the main theorems of welfare economics rely on assumptions concerning the workings of markets.

Contributed By:
Wilfred Beckerman

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