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What is Microeconomics

microeconomics

Definition of Microeconomics

The microeconomics gives focus to the small or micro sections of the economy. Further, this branch of economics studied the individual’s (Households, industry, firm, etc.) economic problems and respective decision making process that how to satisfy their unlimited wants by using the scarce or limited number of resources. 

To better understand the concept of microeconomics we can define it as the study of fulfilling the unlimited wants or desires or maximizing the gain or benefit of an individual, individual family, individual company, individual industry, and so forth, by using scarce resources. Microeconomic theories study the individuals and their behavior towards attainting maximum gain in an economy but do not study the economy as a whole. Microeconomic theories study issues like consumption, distribution, production, pricing, etc. and analyze the behavior of individuals such as person, firm, household, industry, etc.

Scope of Microeconomics

The scope of microeconomics depends upon four questions, which are providing the solution for the problems of consumers. The microeconomic theories provide the answers to these questions and solve consumer problems. The questions are hereunder

  • What to produce? By keeping in view of taste and preferences of the consumers.
  • How much to produce? By keeping in view the demand of consumers.
  • Whom to produce? By keeping in view of the class of society like poor or rich, students or teachers, etc.
  • How someone either consumer or producer utilize the resources in the best possible way. If the concerned one is consumer then how he will maximize his utility or satisfaction. If the concerned one is producer then how he will utilize the resources in the best possible way i.e. how to maximize the production efficiency.
  • How to distribute the resources i.e. goods and services in the society for maximum well being of the society?

Significance and Importance of Microeconomics

  • Understanding micro-level economic operations – The microeconomics concepts or theories help the reader to understand the different market situations in any economy. Further, it helps in decision making by understanding the economic causes behind any market phenomena like what to produce? Why to produce? For whom to produce? How much to produce? and so forth.
  • Resource allocation optimization – The study of microeconomics helps to understand how a firm, company, industry, etc. can maximize production efficiency and profits by apposite allocation and utilization of available resources.
  • Cost Minimization– The microeconomics theories of producer behavior help in determining the optimal point of production for the firm or industry. The theory also makes able the producers in finding the point where production cost is minimum.
  • Understanding of Consumer Behavior – The microeconomics theories of consumer behavior like consumer indifference curves, specific preference hypothesis, marginal utility theory, etc. provides useful information about consumer behavior and, consequently, helps to understand and predict consumer behavior in different market situations.
  • Demand Forecasting – The microeconomics theories like demand theory, demand elasticity, and its analysis help the producers to understand and anticipate product demand and act accordingly.
  • Impact of change in different things on the demand – The microeconomics theories help the producers and consumers to understand that how the demand is being affected by a change in income, price, prices of substitution and complementary goods, etc. which helps both to act relationally.
  • Helping in Policy Making process of Government – The microeconomics theories like demand theory, supply theory, market theory, etc. can assist the government in the development of macro-level policies. For example, the study of microeconomics theories can help the government to determine suitable tax policy, to calculate the impact of the tax in the reduction of income inequality, to design pricing policy for public goods and services, etc.
  • Determination of Exchange rate and Foreign trade – The Microeconomics theories of demand, supply, elasticity of demand and elasticity of supply are helping in understanding the rate of tariff, its impact on the local and international market. Further, these theories help to understand the foreign exchange and determination of exchange rate.  
  • Social Welfare Maximization– The microeconomic theories help in the allocation of resources to the different sectors of the economy for maximizing social welfare. By following these theories social welfare can be achieved.

Basic Microeconomics Concepts

Demand, Supply, and Equilibrium

The demand and supply are two main pillars of economic theories or models. Both are them are model having a relationship with the market price and exists or holds in a perfectly competitive market where no taxes imposed on per unit, no positive or negative externalities, no price control authority. The price of the good or service is the only determinant of supply and demand. When the quantity demanded is equal to the quantity supplied at any prevailing market price that is known as market equilibrium.

Elasticity

Elasticity is a measure of how an economic variable responds to change in another. When one variable has a causal effect on the other variable then elasticity is measured as the ratio of variations in one variable to the variations in another.  For the responsiveness measurement of one variable to the other, this technique has been used regardless of units. There are many types of elasticities but commonly used are income elasticity of demand, supply price elasticity, demand price elasticity, permanent substitution elasticity, substitution elasticity.

Consumer Demand Theory

The consumer preferences for goods and services related to consumer consumption expenses in the consumer demand theory. Further, the relationship between consumer preference and consumption expenses has been used to link the preference with the demand curves. The relationship or link between consumption, personal preferences and demand curve is one of the most studied relationships in economics. This is a way in which consumers balance preferences and expenses by maximizing utility by keeping his or her budget constraint in mind.

The Utility Theory of Consumer Behavior

The utility theory of consumer behavior focused on the maximization of consumer’s utility or satisfaction. It consists of Cardinal Measurement Approach and Ordinal Measurement Approach of utility measurement.

Indifference Preference Analysis

The indifference preference analysis provides the guidelines when the consumer is indifferent among the choice.

Indifference Curve

The indifference curve is the curve that shows the combination of two goods or commodities which provide the same level of satisfaction or utility. For example, let suppose the combination of 3 bananas and 5 apples provide the same utility as a combination of 5 bananas and 3 apples. So both the combinations provide the same level of utility and consumer is indifferent between both.

Marginal Rate of Substitution

 The marginal rate of substitution gives the guidelines to the consumer how much he or she has to sacrifice for attainment of the next combination of goods. Let’s continue the above-mentioned example, in that example for the achievement or attainment of new combination the consumer has to lose or sacrifice 2 apples so it will get 2 extra bananas.

Consumer Equilibrium

The consumer gets equilibrium in two different ways under the cardinal and ordinal approach. This is the point where the consumer gets the highest level of total utility.

Under Cardinal approach of consumer equilibrium, the consumer gets the equilibrium at the point or highest level of utility where marginal utility of each product divided by the respective price of the product provides the same level of utility.

Under the ordinal approach of consumer equilibrium, the consumer gets the equilibrium at the point or highest level of utility where the indifference curve is tangent to the budget line.

Income, Price and Substitution Effect

Income Effect:  It tells the consumers as well as producers that how much demand for any product will be affected by an increase or decrease in the income of the consumer.

Price Effect: It describes how much demand will be affected by the increase or decrease in the price level.

Substitution effect: It describes the effect on demand of any particular product due to change in its price and shifting of the consumer to the best alternative. 

Revealed Preference Theory

This theory describes consumer behavior in a modern way. It states that the purchasing habits of consumer reveal their preferences. 

Theory of Production

The theory of production is the economic process in which resources are converted into outputs or study of production. Producers are producing the goods or services which have demand in the market for example for personal use or gift giving in the economy. This may include storage, manufacturing, packaging, and delivery. The production is defined by some economists in a broader sense as all economic activities in the economy regardless of consumption. They consider any business, except for final purchase, a form of production.

Production Function

It talks about the technical relationship of converting inputs into outputs.

Isoquant Curve

This is the curve most similar to indifference curve but it shows the combination to two inputs which yield the same level of output.

Isocost Curve

It is similar to the budget line. As the consumer has budget constraints similarly the producer also has a budget constraint for purchasing resources. So the isocost curve shows a combination of two different inputs which costs the same total cost.  

Marginal Rate of Technical Substitution

It is similar to the Marginal Rate of Substitution but the core difference is it talks about inputs and prior talk about goods. So, the sacrifice of one combination of input to attain other combination of input is known as the Marginal Rate of Technical Substitution.

Optimal Combination of Resources

The optimal combination of resources is the combination which costs minimum and yield maximum. In other words, the higher rate of production with minimum cost shows the optimal combination of resources.

Costs of Production

The theory of cost of production stated that the price of any goods or services is determined based on the amount which is consumed on the resource that is used to create that good or service. The cost of production depends upon the price of four main resources or factors of production land, labor, capital, and entrepreneur. The technology is also used in the production process but it is seen as fixed capital for example plant or circulating capital, for example, intermediate good.

Opportunity Cost

The concept of opportunity cost is similar to the concept of time constraint. In both cases, someone has to lose or give up the thing or time but can do only one thing at a time.  

You are reading this article right now, the opportunity cost of this reading is the cost of the next best possible alternative you can do. It does not matter how much possible alternatives you have either they are 2 or 200 but the thing which matters in the best possible alternative. So, you can say it that the opportunity cost is independent of several possible choices.  

Opportunity costs possibly let you know that when someone should do something and when not. For example, you might like pancakes, but you like bananas more. If someone just gives you pancakes, you’ll take them. But if you get pancakes or bananas, you will eat a banana. The opportunity cost of eating pancakes is sacrificing the chance of eating bananas. It makes no sense to eat or choose pancakes on the cost of bananas because you like bananas and they will provide more utility or satisfaction.

On the other hand, when you choose the highly desired choice or combination of choices it does not mean that you will not be going to face opportunity cost. If you choose bananas for eating purpose then you face opportunity cost in the form of not eating or losing pancakes. You are willing to sacrifice the pancakes in place of bananas because the opportunity cost, in this case, is lower than another one.

Consequently, the opportunity cost is unavoidable phenomena you have to select the best choice as per your desire and sacrifice the next best alternative.

Market Structure Theories

The market structure, also known as market forms, describes the market features which include the market shares of the firms, number of firms in the market, entrance and exist barrier of the market, competition in the market, and condition of the product either a uniform or not, etc. Many possible market systems are possible in a single market system but it varies from industry to industry.    

Where the economy is not expected to regulate itself government tries to create an atmosphere of competition because the competition works as a regulator of the market system. One of the major examples is construction codes and market competition was absent in it. People were unaware of safety codes than with the time some buildings demolished and some people died and many of them got injured. Companies were not following the construction codes because they cut down their profits. After the deaths of many, the government start intervenes in the market and now companies are adopting safety measure.

The “market type” concept differs from the “market structure” concept. However, it should be noted that there are many types of markets.

Perfect Competition

It is a market situation in which a large number of small firms are working, producing identical products and competing with each other within the same industry. In perfect competition, firms produce the products at minimum prices and a socially optimal output level. In this competition firms are not the decision-makers but decision seekers.

Commonly this condition is known as price takes because they have not enough market share and power to decide their price. The best example of this competition is eBay where a large number of sellers is selling the same product to different consumers or buyers. Further, the consumer in this market has perfect knowledge about the market situation and the product.

Imperfect Competition

In microeconomics, the imperfect competition has some similar features of perfect competition but not all. Under this competition the somehow prices are decided by the firms, etc.

Monopolistic Competition

Monopolistic competition is a market situation in which many products is slightly different like change in the packaging or little bit variations in the product quality and many firms are competing to each other to make market share high. In this case, society gets the benefit as they have more choice or due to product differentiation than the perfect competition but the cost of production is notably higher as compared to perfect competition. Examples of monopolistic competition include cereals, restaurants, footwear, services, and clothing in large cities.

Monopoly

The market structure in which only one or single supplier or firm of a particular good or service is known as Monopoly. This is the situation in which only a single firm or supplier hold the whole market and have the power to decide what price it wants to charge against its goods or services. The reason for its domination is monopolies have not a competition, they charge higher and produce substandard good and ignore social welfare. Wait! Do not make a concept that all the monopolies are bad because the industries exist where firms face higher costs than the profits for example natural monopolies.  

Natural Monopoly: The natural monopoly is the form of monopoly in any industry where one firm faces low costs as compared to other counterpart small firms. 

Oligopoly

Oligopoly is a market structure in which a few companies (oligopolists) dominate the market or industry. Under oligopolies, these few firms or companies create the cartels and engage in collusion to charge high prices by reducing the output.

Alternatively, if these companies or firms are not agreeing for cartel or collusion then the oligopoly will be competitive and involved in advertising campaigns to get higher market share.  

Duopoly: It comes under the umbrella of oligopoly and in this case, only two firms compete for higher market share. Game theory clears the planning or situation of a competitor in oligopolies and duopolies.

Monopsony

This is the form of market structure where many sellers and one buyer exist.

Oligopsony

This is the form of market structure where few buyers in the market and many sellers. Simply, the market situation in which sellers are more than the buyers in the market is known as oligopsony.

In competitive markets the consumer surplus is higher and producer surplus is low while in noncompetitive markets the consumer surplus is low and producer surplus is high.

Being Economist

Limitations of Microeconomics

  • Microeconomics theories assume the level of full employment in the economy but in actual no economic system or economy in this world faced full employment till date. Consequently, this assumption is not more than an unrealistic dream.
  • The microeconomics theories always assumed that there is a “Lassiez Faire” economy having no government intervention. But in the real world, not the market structure is working purely free or without the intervention of government. Even the capitalist economies whose slogan is free markets they also intervene in the market on very regularly.
  • Most of the microeconomics theories adopted the ‘Ceteris Paribus’ assumption that means “other things or circumstances remains the same or constant.” But in the real-world nothing remains constant, business conditions, business atmosphere, costs of production, etc. so this is again an unrealistic assumption.
  • The microeconomics theories generalized individual behavior and individual behavior does not represent the overall population but maybe sometimes. So, it is not always the case.
  • Microeconomics theories focused on individual behavior and represent a small part of the economy. Therefore, it does not very much helping us in understanding the whole economic system.
Muhammad Waqas Khalid
About Him: He has done Master of Philosophy in Economics in 2016 by paying special attention to the development of research skills. He has worked as a Research Associate at the London School of Economics. He has 6 years of experience in writing. He has published many research articles and some of them got published in impact journals too. Check his work at Google Scholar: https://scholar.google.com/citations?user=RiGg9YIAAAAJ&hl=en His Expertise: He has both quantitative and qualitative expertise. He has command over different statistical packages/software i.e. SPSS, Eviews, STATA, Microfit, MS Excel, etc. and He is willing to help you out in your assignments or thesis etc.
http://www.beingeconomist.com

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