Microeconomics is a branch of economics that studies the behavior of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms. Microeconomics focuses on the study of individual markets, sectors, or industries as opposed to the economy as a whole, which is studied in macroeconomics.
One goal of microeconomics is to analyze the market mechanisms that establish relative prices among goods and services and allocate limited resources among alternative uses. Microeconomics shows conditions under which free markets lead to desirable allocations. It also analyzes market failure, in which markets fail to produce efficient outcomes.
While microeconomics focuses on firms and individuals, macroeconomics focuses on the overall level of economic activity, addressing issues of growth, inflation, and unemployment—and national policies related to these issues. Microeconomics also deals with the effects of economic policies (such as changing taxation levels) on microeconomic behavior and thus on the aforementioned aspects of the economy. Particularly in the wake of the Lucas critique, much of modern macroeconomic theory has been built upon microfoundations—i.e., based upon basic assumptions about micro-level behavior.
Assumptions and definitions Microeconomic study historically has been performed according to general equilibrium theory, developed by Léon Walras in Elements of Pure Economics (1874) and partial equilibrium theory, introduced by Alfred Marshall in Principles of Economics (1890).
Microeconomic theory typically begins with the study of a single rational and utility maximizing individual. To economists, rationality means an individual possesses stable preferences that are both complete and transitive.
The technical assumption that preference relations are continuous is needed to ensure the existence of a utility function. Although microeconomic theory can continue without this assumption, it would make comparative statics impossible since there is no guarantee that the resulting utility function would be differentiable.
Microeconomic theory progresses by defining a competitive budget set, which is a subset of the consumption set. It is at this point that economists make the technical assumption that preferences are locally non-satiated. Without the assumption of LNS (local non-satiation), there is no 100% guarantee, but there would be a rational increase in individual utility. With the necessary tools and assumptions in place, the utility maximization problem (UMP) is developed.
The utility maximization problem is the heart of consumer theory. The utility maximization problem attempts to explain the action axiom by imposing rationality axioms on consumer preferences and then mathematically modeling and analyzing the consequences. The utility maximization problem serves not only as the mathematical foundation of consumer theory but as a metaphysical explanation of it as well. That is, the utility maximization problem is used by economists not only to explain what or how individuals make choices, but also why they do so.
The utility maximization problem is a constrained optimization problem in which an individual seeks to maximize utility subject to a budget constraint. Economists use the extreme value theorem to guarantee that a solution to the utility maximization problem exists. That is, since the budget constraint is both bounded and closed, a solution to the utility maximization problem exists. Economists call the solution to the utility maximization problem a Walrasian demand function or correspondence.
The utility maximization problem has so far been developed by taking consumer tastes (i.e., consumer utility) as primitive. However, an alternative way to develop microeconomic theory is by taking consumer choice as primitive. This model of microeconomic theory is referred to as revealed preference theory.
The theory of supply and demand usually assumes that markets are perfectly competitive. This implies that there are many buyers and sellers in the market, and none of them has the capacity to influence the prices of goods and services significantly. In many real-life transactions, the assumption fails because some individual buyers or sellers can influence prices. Quite often, a sophisticated analysis is required to understand the demand-supply equation of a good model. However, the theory works well in situations meeting these assumptions.
Mainstream economics does not assume a priori that markets are preferable to other forms of social organization. In fact, much analysis is devoted to cases where market failure leads to resource allocation that is suboptimal and creates deadweight loss. A classic example of suboptimal resource allocation is that of a public good. In such cases, economists may attempt to find policies that avoid waste, either directly by government control, indirectly by regulation that induces market participants to act in a manner consistent with optimal welfare, or by creating "missing markets" to enable efficient trading where none had previously existed.
This is studied in the field of collective action and public choice theory. "Optimal welfare" usually takes on a Paretian norm, which is a mathematical application of the Kaldor–Hicks method. This can diverge from the Utilitarian goal of maximizing utility because it does not consider how goods are distributed among people. Market failure in positive economics (microeconomics) has limited implications when the economist's beliefs are not mixed with their theory.
The demand for various commodities by individuals is generally thought of as the outcome of a utility-maximizing process, with each individual seeking to maximize their own utility subject to a budget constraint and a given consumption set.
Allocation of scarce resources Individuals and firms need to allocate limited resources to ensure all agents in the economy are well off. Firms decide which goods and services to produce, considering low costs involving labour, materials, and capital as well as potential profit margins. Consumers choose the goods and services they want that will maximize their happiness, taking into account their limited wealth.
The government can make these allocation decisions, or consumers and firms can make them independently. For example, in the former Soviet Union, the government played a role in informing car manufacturers which cars to produce and which consumers would gain access to them.
History
Economists commonly consider themselves microeconomists or macroeconomists. The difference between microeconomics and macroeconomics was likely introduced in 1933 by the Norwegian economist Ragnar Frisch, the co-recipient of the first Nobel Memorial Prize in Economic Sciences in 1969. Republished as: However, Frisch did not actually use the word "microeconomics", instead drawing distinctions between "micro-dynamic" and "macro-dynamic" analysis in a way similar to how the words "microeconomics" and "macroeconomics" are used today. The first known use of the term "microeconomics" in a published article was from Pieter de Wolff in 1941, who broadened the term "micro-dynamics" into "microeconomics".
Microeconomic theory
Consumer demand theory
Consumer demand theory relates preferences for the consumption of both goods and services to the consumption expenditures; ultimately, this relationship between preferences and consumption expenditures is used to relate preferences to consumer demand curves. The link between personal preferences, consumption, and the demand curve is one of the most closely studied relations in economics. It is a way of analyzing how consumers may achieve equilibrium between preferences and expenditures by maximizing utility subject to consumer budget constraints.
Production theory
Production theory is the study of production, or the economic process of converting inputs into outputs. Production uses resources to create a good or service that is suitable for use, gift-giving in a gift economy, or exchange in a market economy. This can include manufacturing, storing, shipping, and packaging. Some economists define production broadly as all economic activity other than consumption. They see every commercial activity other than the final purchase as some form of production.
Cost-of-production theory of value
The cost-of-production theory of value states that the price of an object or condition is determined by the sum of the cost of the resources that went into making it. The cost can comprise any of the factors of production (including labor, capital, or land) and taxation. Technology can be viewed either as a form of fixed capital (e.g. an industrial plant) or circulating capital (e.g. intermediate goods).
In the mathematical model for the cost of production, the short-run total cost is equal to fixed cost plus total variable cost. The fixed cost is the cost incurred regardless of how much the firm produces. The variable cost is a function of the quantity of an object being produced. The cost function can be used to characterize production through the duality theory in economics, developed mainly by Ronald Shephard (1953, 1970) and other scholars (Sickles & Zelenyuk, 2019, ch. 2).
Fixed and variable costs Fixed cost (FC) – This cost does not change with output. It includes business expenses such as rent, salaries, and utility bills. Variable cost (VC) – This cost changes as output changes. This includes raw materials, delivery costs, and production supplies.
Over a short period (a few months), most costs are fixed, as the firm must pay salaries, contracted shipments, and materials used to produce various goods. Over a longer time period (2-3 years), costs can become variable. Firms can decide to reduce output, purchase fewer materials, and even sell some machinery. Over 10 years, most costs become variable as workers can be laid off or new machinery can be bought to replace the old machinery
Sunk costs – This is a fixed cost that has already been incurred and cannot be recovered. An example of this can be seen in R&D, such as in the pharmaceutical industry. Hundreds of millions of dollars are spent to achieve new drug breakthroughs, but this is challenging as it's increasingly harder to find breakthroughs and meet tighter regulatory standards. Thus, many projects are written off, leading to losses of millions of dollars
Opportunity cost
Opportunity cost is closely related to the idea of time constraints. One can do only one thing at a time, which means that, inevitably, one is always giving up other things. The opportunity cost of any activity is the value of the next-best alternative one could have pursued instead. Opportunity cost depends only on the value of the next-best alternative. It does not matter whether one has five alternatives or 5,000.
Opportunity costs can tell when not to do something as well as when to do something. For example, one may like waffles, but like chocolate even more. If someone offers only waffles, one would take them. But if offered waffles or chocolate, one would take the chocolate. The opportunity cost of eating waffles is sacrificing the chance to eat chocolate. Because the cost of not eating the chocolate is higher than the benefits of eating the waffles, it makes no sense to choose waffles. Of course, if one chooses chocolate, they still face the opportunity cost of giving up waffles. But one is willing to do that because the waffle's opportunity cost is lower than the chocolate's benefits. Opportunity costs are unavoidable constraints on behavior because one has to decide what's best and give up the next-best alternative.
Price theory