Microeconomics

I

INTRODUCTION

Microeconomics, branch of economics that deals with small units, including individual companies and small groups of consumers. Economics is concerned with the allocation of scarce means among competing ends. People 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 (labor, capital, and raw materials) and the existing technology. Microeconomics is the study of how these resources are allocated to the satisfaction of 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. It is not always possible to make a distinction between microeconomics and macroeconomics. For example, the difference between conflicting schools of thought in macroeconomics is sometimes traced to differences in assumptions related to microeconomics.

II

COMPONENTS OF MICROECONOMICS

The central components of microeconomics are demand, supply, and market equilibrium. Demand refers to how individuals or households form their demands for different goods and services. Supply refers to how firms decide which and how many goods or services they will supply and what combination of factors of production they should employ in supplying them. Market equilibrium refers to how markets enable these supplies and demands to interact. Other important subsections of microeconomic theory include welfare economics and public finance (see Supply and Demand).

III

DEMAND

Microeconomics builds on certain simplifying assumptions concerning the behavior of consumers and producers. For example, the theory of consumers' demand (how consumers make purchase decisions) assumes that consumers are rational, that is, they want to make the decision that will give them the greatest satisfaction, known as maximizing their utility. The optimal choice for a consumer, therefore, is that choice among the available options that will enable him or her to maximize utility. The options available to the consumer are determined by his or her purchasing power (a function of income and access to capital, including credit), and the prices of the goods and services available. Given the information available concerning these options, the consumer's utility-maximizing choice will depend on his or her preference patterns (how the consumer believes that the different combinations of goods and services will affect his or her total utility). Although the assumptions on which demand theory is based are known to be only partially valid, they allow economists to predict more precisely how consumers and producers are likely to behave.

The microeconomic theory of consumers' demand 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—purchasing power, the prices of the goods and services available, and preference patterns. For example, demand theory enables economists to predict how the consumer's choice will be affected by changes in the price of a product or service. The elementary demand theory also explains certain paradoxical phenomena, such as why in some cases demand is not inversely correlated with price—why diamonds, which are far less important in life than water, are usually far more expensive.

The individual is not assumed to be simply a consumer. In order to acquire purchasing power in the form of income, an individual must sell his or her labor. One basic choice an individual must make, therefore, is between income and leisure. An individual's optimal decision is the one where marginal utility (the additional benefit of an additional unit of a good or service) of income and leisure equals the price of labor—the wage. The demand theory explains, for example, why a rise in wages will sometimes create an increase in the supply of labor and sometimes induce a decrease. An individual will choose labor over leisure only as long as wages are worth more to the individual than leisure. An increase in wages may entice some people to work instead of enjoying leisure time. Others may not wish to give up any leisure time, and would choose to work fewer hours for greater pay. Similarly, the consumer has to choose between consumption at different points in time. By abstaining from consumption in order to invest, he or she has the opportunity of consuming more at a later period.

However, one factor that the consumer must take into account in saving and consumption decisions, as in all other decisions, is the risk involved. One branch of microeconomic theory, therefore, deals with optimal choice under conditions of uncertainty; this branch, which has links with game theory, is used by the insurance industry.

IV

SUPPLY

The theory of supply explains the behavior of economic agents acting in their capacity as producers. Here, the basic assumption is that firms attempt to maximize profits. This corresponds to the basic assumption of demand theory that consumers attempt to maximize utility. However, this simplifying assumption is 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, bonuses, power, and prestige, which may depend on the firm's size and acquisitions as much as on its profitability. In the longer term, however, shareholders can exert their influence to induce firms to maximize long-term profits.

Even assuming a simple profit-maximization model for the firm, there are still many obstacles to finding a simple model of the determination of supply of any commodity. In the short run, the profit-maximization assumption leads to fairly clear predictions concerning the size 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 the factors of production and a firm's output. This relationship is called a production function and corresponds to the relationship in demand theory between the consumption of any good and the consumer's marginal utility. Production functions are the basis for determining how average costs and marginal costs (the costs of producing one more unit of output) vary with the size of the output. Once these variations are known, the firm can establish the most profitable level of output for any commodity, and the most profitable combination of factors of production.

Supply theory also provides a basis for short-term predictions concerning the way that firms vary their demand for factors of production in response to changes in the relative prices of these factors. There is a considerable body of theory concerning the way that firms bargain with their employees, and the extent to which a firm's employment practices are motivated by simple wage considerations, rather than by more sophisticated concerns with employee morale or with the extent to which on-the-job training has added to the value of the existing labor force. Such theories help explain why, for example, unemployed people do not usually succeed—except perhaps in the most unskilled occupations—in inducing firms to hire them at a lower wage if this means the firm will have to fire some existing employees. This is an example of the microeconomic foundations of some topics in macroeconomics.

While supply theory can provide reliable explanations and predictions of short-run behavior by firms, predictions are more difficult once beyond the period in which capacity is assumed to be more or less fixed. In the longer term, the variables introduced by potential change significantly complicate the prediction process.

By taking consumers' components from demand theory and putting them together with firms' supply components from supply theory, it is possible to construct models of how markets operate. 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 their underlying determinants. Thus, for example, fairly confident and precise predictions can be made about how changes in consumers' preferences or in technology are likely to affect demand, supply, and equilibrium output, but only under conditions of perfect competition.

Although 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. Some markets may be more or less complete monopolies, in which only one producer supplies the entire market for a particular product. Other markets are dominated by a handful of major suppliers; they are oligopolies. Many markets exhibit the characteristics of imperfect competition, although they are not dominated by one or a few suppliers. This would be the case, for example, in a market where consumers are not well informed about the prices and qualities offered by competing sellers. Perfect competition requires that all buyers be aware of all the prices that competing sellers are proposing. Such information is never available except, perhaps, in very small, local markets. Consumers may also be attached to specific suppliers because of proximity, habit, reliability, quality, and other determinants of consumer loyalty, thereby creating an imperfect market for the product or the sales outlet in question.

V

MARKET EQUILIBRIUM

The third major component of microeconomic theory is the theory of how markets operate to bring about an equilibrium between demand and supply. This theory describes how markets operate under different degrees of competition. This is not too difficult in markets with a 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 some threat of competition from alternative sources of energy—such as gas or oil—usually exists and can constrain the profit-maximization behavior of a monopolist, particularly in the longer term. When a market is dominated by a few major suppliers—conditions of oligopoly prevail—the theory of market equilibrium employs game theory, a way of analyzing competitive situations in which two or more opponents pursue conflicting goals.

The three components of microeconomics—demand, supply, and market equilibrium—provide a foundation for almost any branch of economics. For example, an economist working in public finance who wants to analyze the effects of imposing a tax (a macroeconomic strategy) must use microeconomic models to show how the tax will affect supply, demand, and price, and hence the revenue that it may generate or how it will affect the supply of factors of production. An income tax might discourage the supply of labor and a profits tax might discourage the level of investment. Similarly, the main theorems of welfare economics rely on microeconomic assumptions concerning the workings of markets.