What is Microeconomics?

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Definition:

Microeconomics is the study of decisions made by individual consumers and firms, the factors that affect those decisions, and how those decisions affect others.

🤔 Understanding microeconomics

Microeconomics is a branch of social science that studies small decisions – In other words, it examines the effects that individual and company behaviors have on specific markets. More precisely, it studies how these market actors allocate scarce resources and how these decisions affect supply and demand, pricing, and production. Although both microeconomics and macroeconomics study individual decisions and markets, macroeconomics studies them in order to extrapolate broader theories about an economy as a whole. For example, macroeconomics may analyze unemployment rates, inflation rates, and interest rates, whereas microeconomics may study how a company determines what to produce, how much to charge, and how many workers to hire. Historically, microeconomics has been regarded as the study of rational choice and largely relied on mathematical models to draw its conclusions. However, some microeconomists have started to integrate elements of psychology, sociology, and other sciences into the field.

Example

Imagine that there’s a baker, Jim, who lives in a town of 500 people. Each day, 100 people buy Jim’s fresh bread and other delicious pastries. Although this provides him with enough income to sustain his family, he wonders if there might be a way to increase sales. He starts to scope out the local competition and realizes that many people in the town go to a different baker who sells baked goods for $1 less on average. Jim realizes that he may be able to sell more and increase his overall profits if he lowers his prices, so he reduces them by $1.50 on average to undercut his competition. This price reduction is appealing to buyers, so he soon starts attracting more customers. Because of this, he starts baking and selling more treats. This interaction amongst Jim, local competitors, and consumers is an example of microeconomics at work.

Takeaway

Microeconomics is kind of like focusing on your nutrition...

It takes a lot more than just eating well to live a healthy life. You need to exercise, take care of your hygiene, visit your doctor regularly, and take medications when necessary. But nutrition is still a big part of staying healthy, so it’s important to ask questions like: What are the healthiest foods? What are the tradeoffs between enjoyment and health? Is it okay to have junk food every now and then, or should it be avoided entirely? Similarly, microeconomics looks at individual markets and small decisions instead of economies as a whole. While figuring out how specific markets work is no substitute for understanding entire economies as a whole, microeconomics can provide a strong foundation – just like proper nutrition can provide a good base for a healthy lifestyle.

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What is Microeconomics?

Microeconomics is the study of how limited (aka scarce) resources are allocated to meet unlimited human desires. It looks at the decisions people and businesses make, and how these choices affect markets (i.e. places where two or more parties trade).

Microeconomics is a social science, which means that it focuses on human behavior. It is one of the two main branches of economics, along with macroeconomics. Unlike other fields of study that examine human behavior, such as psychology or sociology, microeconomics specifically examines behavior as it pertains to material wealth and resource allocation.

At its core, microeconomics seeks to create reliable mathematical models that can be used to understand markets (e.g., the aerospace or technology industry) and individual behavior. When these models are applied, they can help businesses and consumers improve their decision-making by illustrating the optimal choice based on what we know about human behavior.

Economists rely on certain assumptions to make these models, such as the idea that humans act rationally and in their own self interest. These assumptions are generally accepted because of the significant scientific evidence behind them and because they have led to reproducible results over many years.

However, not all economists agree with these assumptions, with some positing that humans instead act irrationally. Because of these sorts of disagreements and reliability issues surrounding all social sciences, microeconomic models are sometimes not as steadfast and replicable as ones from physical sciences – but they are still important and useful as relatively reliable guideposts.

Further, microeconomics relies largely on theoretical market structures – These are useful to inform decision-making, even though many are never exactly replicated in the real world. For example, perfect competition – a market structure where competition is at its highest possible level and no individual buyer or seller can influence the market price of products – never actually occurs in real life. Still, by studying perfectly competitive markets, economists can simplify real-world markets and make reasonably accurate economic predictions and theories.

What are the basic concepts of microeconomics?

At its heart, the study of microeconomics examines consumer behavior, firm behavior, and market structures (e.g., monopolies and oligopolies) – and the relationships among them. This study is typically approached mathematically and graphically.

Although microeconomics is a deep field of study, it’s built out of relatively few key economic concepts. These include, but are not limited to:

  • Supply and demand: The law of supply and demand explains the relationship between buyers and sellers – In general, when supply is high and demand is low, prices go down. Conversely, when demand is high and supply is low, prices go up. For example, when a new gadget like an iPhone is released, there often isn’t enough supply to meet the demand. Customers line up and wait long hours to get one of the first few products – Some make the purchase with the intention of reselling it at a higher price. Since there’s a shortage, people may be willing to pay this higher price to get one of the few available units. Once supply increases, the opportunity to raise prices goes away as supply and demand even out.
  • Scarcity: People have unlimited desires, but there are limited resources to fulfill them. Scarcity refers to the gap between the supply and the demand for a resource. Microeconomics studies how people deal with this reality by making tradeoffs and judging the opportunity cost (the value of an alternative choice that an individual or business misses out on when making another decision instead). Imagine a business with a $6 million marketing budget. It could spend that money on a single Super Bowl ad or put it towards other marketing efforts, like social media or billboards. Because the business doesn’t have unlimited resources, it can’t pursue all of those avenues — That’s scarcity. If it chooses the Super Bowl ad, then the unchosen options are the opportunity cost.
  • Utility theory: This concept explores how people maximize utility (aka the satisfaction they get from their economic decisions). Marginal utility, for example, examines how much benefit people derive from an additional unit of something – How much happier will you be with two ice cream cones instead of one?
  • Production theory: This examines how firms make decisions about how much of a good or service to produce, and how much raw material it will use to achieve that. For example, if an automaker decides to produce 100 cars per day, how many workers should they hire?

How are these concepts applied in microeconomics?

The concepts described in the last section are used to solve a variety of issues in microeconomics, including:

  • Determining equilibrium prices: The point where supply and demand meet on supply and demand curves is the equilibrium price for a good or service — There is no surplus supply or desire for a good or service. Producers meet all demand, and no one produces extra units of the good or service.
  • The labor supply decision: This explores how employees decide the amount they want to work by weighing the opportunity cost of labor versus leisure since time is a scarce resource.
  • The consumer utility maximization problem: This applies utility theory by seeking to understand how consumers can allocate their money and income to maximize their utility (aka their satisfaction or happiness).
  • The firm’s cost minimization problem: This topic applies production theory to understand how firms can keep costs as low as possible when producing goods or services.

What is the difference between microeconomics and macroeconomics?

Microeconomics studies only a portion of an economy, whereas macroeconomics studies that entire economy.

Microeconomics deals with the decisions and behaviors of individuals and firms. It answers questions, such as: What is the optimal amount of time to spend working? What is the best way to spend your income? How much product should a business produce? Microeconomics looks at individual actors and the markets they make, but it doesn’t go beyond that.

Macroeconomics takes many markets, aggregates them, and then studies their emergent phenomena (aka the economies they create). It asks questions like: What is the best monetary policy? At what level should central banks set interest rates? What could be done to reduce unemployment?

Why is microeconomics important?

No matter how much money you have, everyone deals with scarcity and must make tough decisions about where to allocate their resources. Even Jeff Bezos, the richest man in the world as of March 2020, could run out of money if he isn’t careful — He just doesn’t have to be as careful as someone who only has $50 to their name.

Microeconomics is, in some ways, the study of how people and firms can make better economic and financial decisions. For consumers, that might mean deciding how much time you should spend working vs. relaxing. For businesses, that might mean figuring out how much of your product you should manufacture to make an optimal profit.

Sometimes, microeconomics can have an immediate impact on your life, such as when you’re evaluating the marginal utility (aka the satisfaction that comes from one additional unit) of buying two slices of pizza instead of just one. Other times, it may have a more indirect effect, such as by helping you become a more informed consumer and understand why a company prices its products a certain way.

You make dozens of small, economic decisions every day — Everyone can benefit from learning a bit more about the things they do each day. As the American economist and former Chair of the Federal Reserve, Ben Bernanke, once said, “The ultimate purpose of economics, of course, is to understand and promote the enhancement of wellbeing.” Everyone could do with a little more of that.

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