Microeconomics

The Basic Idea

Microeconomics is a branch of economics that studies how individuals, households and businesses make decisions about how to use and distribute resources. By studying the mechanisms behind how these decisions are made, microeconomics enables us to understand concepts such as how prices are determined, what factors impact our decision to purchase goods, and how businesses can allocate their resources to increase efficiency.2

The study of microeconomics takes a bottom-up approach by examining how economic decisions are made at an individual level, in contrast to macroeconomics, which focuses on large-scale economic activity such as economic growth, employment and government policies.3 One of the main themes that microeconomics revolves around is the concept of supply and demand. The law of supply and demand explains the relationship between the price of a good or service, and the willingness of people to buy or sell it.4 Generally speaking, if the price of a good/service increases, then businesses would be willing to supply more of it, whereas buyers would demand less of it. The opposite is true too, such that when the price decreases, suppliers would be less willing to supply and buyers would be more willing to buy. Together, supply and demand interact to determine the market equilibrium, which is the optimal price where the quantity demanded by buyers is equal to quantity supplied by producers.4

We constantly see concepts such as supply and demand in our daily lives, even though we may not be consciously aware that they are the building blocks of microeconomics. For example, if a clothing store has too many winter jackets because customers are not buying them, they may decide to offer a discount on the winter jackets, which may then increase consumer demand and therefore solve the problem of the excess supply. By understanding microeconomic concepts and mechanisms, economists can predict how individuals and businesses will behave in response to changes in prices, resources, or incentives.2

We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production.

– Alfred Marshall, Principles of Economics

History

Microeconomics has its roots in Adam Smith’s theory of the free market, which has been applied to explain how market competition leads to price adjustment until an equilibrium point is reached. Many of Smith’s ideas from his well-known book, The Wealth of Nations (1776), have been developed into ideas commonly discussed in contemporary microeconomics, such as division of labour, externalities, and market failures.5 His work is often compared to the philosophy of utilitarianism, which suggests that humans are motivated by pursuing pleasure and avoiding pain. This was applied to economics, through the idea that individuals in a market act to maximize their benefit when participating in economic transactions.

Another key figure in microeconomics was Alfred Marshall, whose 1890 book, Principles of Economics, established economic models and theories that are still in use today. In particular, Marshall developed the supply and demand curve, which is widely used to this day in understanding market equilibrium. Marshall is also known for contributing key microeconomics concepts such as price elasticity of demand, which is a measure of how sensitive customer demand is to changes in price.5

In 1933, Ragnad Frisch was the first person to explicitly distinguish between microeconomics and macroeconomics. Although he did not use these exact terms and instead talked about the differences between “micro-dynamic” and “macro-dynamic” economic analysis, he is the first person known to describe the distinctions between these two branches of economics.6 In 1941, Pieter de Wolff developed on Fricsh’s distinction between two branches of economics, by expanding Frisch’s use of “micro-dynamic” to the more general term of “microeconomics,”  which was the first known usage of this term.7

Consequences

Studying how individuals make economic decisions, allocate resources, and respond to incentives can allow us to develop a clearer understanding of how consumers and businesses interact with the economic market. This can be applied to many aspects of our daily lives, as well as an extensive range of other fields and disciplines. For example, labor economics is a specialized area of study that takes concepts from microeconomics and applies it towards labor or job markets. In labor economics, the laws of supply and demand can be extended to the interaction of workers and employers, with employees represented by the supply of labor, and employers representing the demand of labor.8 As a result, by studying the interaction between the two, we can gain a greater understanding about issues relating to income and employment.

Another example of how microeconomics can be applied is in the field of public policy, when considering whether the government should intervene in order to address issues such as externalities, which are an example of market failure. 9 Externalities occur when an individual’s consumption/ a business’s production has an external effect on others. One common example of this is the issue of pollution produced by factories, as this is a negative cost to society, but the producer is not paying for it. As a result, governments may intervene by imposing carbon emissions taxes on the factories, in order to increase the factory’s costs with the aim of providing an incentive for them to reduce their emissions.9

Externalities are not always negative. There are positive externalities too, where one’s consumption or production has a wider benefit for society.These are also examples of market failure because in the case of positive externalities, the good or service is being under-consumed or under-produced. One example of positive externalities that is relevant towards the current Covid-19 pandemic is the issue of vaccination. By getting vaccinated, apart from protecting oneself, there is also a wider benefit to society, especially if enough people get vaccinated in order to achieve herd immunity. As a result, governments may try and increase the number of people getting vaccinated, as there is a greater effect for society as a whole when an individual gets vaccinated. One way of tackling positive externalities is to reduce prices in order to encourage consumption. In the case of the vaccines this can be seen by governments subsidising the vaccines and offering them to the public at no cost, in order to encourage more citizens to take the vaccine, which will lead to greater benefits for the society as a whole.

Limitations

While microeconomics is well-established as one of the key branches of economics, one of its biggest limitations is that we are unable to explain the functioning of an economy by solely examining economic decisions at the individual level. As a result, microeconomics is unable to explain some of the topics that macroeconomics deals with relating to the functioning of the economy of a whole, such as issues of unemployment.

Microeconomics is also based on the assumption that individuals are rational, and act in ways to maximize their utility. However, as we can see from the development of the field of behavioral economics, individuals do not always act in a “rational” manner, and many other factors are involved in the decision making process.

Furthermore, many microeconomics theories work under the assumption that the market is perfectly competitive, meaning that there are many buyers and many sellers, and none of them can individually influence the price of goods or services. However, in reality this is often not the case, and so these theories and models may not be as applicable to environments where individual consumers or companies can actually influence the price of goods/ services.

Related TDL resources

A profile on Alfred Marshall, detailing his background and how he developed the ideas that transformed the field of modern economics, including his well-known book, Principles of Economics.

A guide on one of the core concepts in microeconomics, scarcity, and how it relates to the key economic questions of how resources should be allocated.

The Consumer Upside Of An Economic Downturn: This article discusses how consumer behavior is impacted by economic recessions in ways that we may not expect.

This article provides a review of the book Poor Economics, by Abhijit Banerjee and Esther Duflo, describing how it provides a microeconomics lens to prevalent issues in developmental economics.

Sources

  1. Alfred Marshall. The Decision Lab. https://thedecisionlab.com/thinkers/economics/alfred-marshall/
  2. Investopedia Staff (2020). Microeconomics. Investopedia. https://www.investopedia.com/terms/m/microeconomics.asp
  3. Guide to Microeconomics. Investopedia. https://www.investopedia.com/articles/economics/08/understanding-microeconomics.asp
  4. Fernando, J. (2020). Law of Supply and Demand. Investopedia. https://www.investopedia.com/terms/l/law-of-supply-demand.asp
  5. Investopedia. (2019). Who Discovered the Law of Supply and Demand? Investopedia.  https://www.investopedia.com/ask/answers/030415/who-discovered-law-supply-and-demand.asp
  6. Frisch, R. (1933). Propagation problems and impulse problems in dynamic economics. Economic Essays in Honour of Gustav Cassel, Allen & Unwin, London, 1933, pp. 171–3, 181–90, 197–203. https://doi.org/10.1017/CBO9781139170116.032
  7. De Wolff, P. (1941). Income Elasticity of Demand, a Micro-Economic and a Macro-Economic Interpretation. The Economic Journal. 51 (201): 140–145. https://www.jstor.org/stable/2225666?
  8. Kenton, W. (2020). Labor Market. Investopedia. https://www.investopedia.com/terms/l/labor-market.asp
  9. Kenton, W. (2020). Externality. Investopedia. https://www.investopedia.com/terms/e/externality.asp

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