An intro to Microeconomics

A beginner’s guide to understanding microeconomics. Primarily sourced from Investopedia. Check them out here

What Is It?

Microeconomics focuses on the role consumers and businesses play in the economy, with specific attention paid to how these two groups make decisions. These decisions include when a consumer purchases a good and for how much, or how a business determines the price it will charge for its product. Microeconomics examines smaller units of the overall economy; it is different than macroeconomics, which focuses primarily on the effects of interest rates, employment, output, and exchange rates on governments and economies as a whole. Both microeconomics and macroeconomics examine the effects of actions in terms of supply and demand.

Microeconomics breaks down into the following tenets:

• Individuals make decisions based on the concept of utility. In other words, the decision made by the individual is supposed to increase that individual’s happiness or satisfaction. This concept is called rational behavior or rational decision-making.
• Businesses make decisions based on the competition they face in the market. The more competition a business faces, the less leeway it has in terms of pricing.
• Both individuals and consumers take the opportunity cost of their actions into account when making their decisions.

Total and Marginal Utility

At the core of how a consumer makes a decision is the concept of individual benefit, also known as utility. The more benefit a consumer feels a product provides, the more that consumer is willing to pay for the product. Consumers often assign different levels of utility to different goods, creating different levels of demand. Consumers have the choice of purchasing any number of goods, so utility analysis often looks at marginal utility, which shows the satisfaction that one additional unit of a good brings. Total utility is the total satisfaction the consumption of a product brings to the consumer.

Utility can be difficult to measure and is even more difficult to aggregate in order to explain how all consumers will behave. After all, each consumer feels differently about a particular product. Take the following example:

Think of how much you like eating a particular food, such as pizza. While you might be really satisfied after one slice, that seventh slice of pizza makes your stomach hurt. In the case of you and pizza, you might say that the benefit (utility) that you receive from eating that seventh slice of pizza is not nearly as great as that of the first slice. Imagine that the value of eating that first slice of pizza is set to 14 (an arbitrary number chosen for the sake of illustration).

Figure 1, below, shows that each additional slice of pizza you eat increases your total utility because you feel less hungry as you eat more. At the same time, because the hunger you feel decreases with each additional slice you consume, the marginal utility—the utility of each additional slice—also decreases.

The decreasing satisfaction the consumer feels from additional units is referred to as the law of diminishing marginal utility. While the law of diminishing marginal utility isn’t really a law in the strictest sense (there are exceptions), it does help illustrate how resources spent by a consumer, such as the extra dollar needed to buy that seventh piece of pizza, could have been better used elsewhere.

For example, if you were given the choice of buying more pizza or buying a soda, you might decide to forgo another slice in order to have something to drink. Just as you were able to indicate in a chart how much each slice of pizza meant to you, you probably could also indicate how you felt about combinations of different amounts of soda and pizza. If you were to plot out this chart on a graph, you’d get an indifference curve, a diagram depicting equal levels of utility (satisfaction) for a consumer faced with various combinations of goods.

Opportunity Costs

When consumers or businesses make the decision to purchase or produce particular goods, they are doing so at the expense of buying or producing something else. This is referred to as the opportunity cost. If an individual decides to use a month’s salary for a vacation instead of saving, the immediate benefit is the vacation on a sandy beach, but the opportunity cost is the money that could have accrued in that account in interest, as well as what could have been done with that money in the future.

When illustrating how opportunity costs influence decision making, economists use a graph called the production possibility frontier (PPF). Figure 5 shows the combinations of two goods that a company or economy can produce. Points within the curve (Point A) are considered inefficient because the maximum combination of the two goods is not reached, while points outside of the curve (Point B) cannot exist because they require a higher level of efficiency than what is currently possible. Points outside the curve can only be reached by an increase in resources or by improvements to technology. The curve represents maximum efficiency.

The graph represents the amount of two different goods that a firm can produce, but instead of always seeking to produce along the curve, a firm might choose to produce within the curve’s boundaries. The firm’s decision to produce less than what is efficient is determined by the demand for the two types of goods. If the demand for goods is lower than what can be efficiently produced, then the firm is more likely to limit production. This decision is also influenced by the competition faced by the firm.

A well-known example of the PPF in practice is the “guns and butter” model, which shows the combinations of defense spending and civilian spending that a government can support. While the model itself oversimplifies the complex relationships between politics and economics, the general idea is that the more a government spends on defense, the less it can spend on non-defense items.

Market Failure and Competition

While the term market failure might conjure up images of unemployment or a massive economic depression, the meaning of the term is different. Market failure exists when the economy is unable to efficiently allocate resources. This can result in scarcity, a glut or a general mismatch between supply and demand. Market failure is frequently associated with the role that competition plays in the production of goods and services, but can also arise from asymmetric information or from a misjudgment in the effects of a particular action (referred to as externalities).

The level of competition a firm faces in a market, as well as how this determines consumer prices, is probably the more widely-referenced concept. There are four main types of competition:

• Perfect Competition: A large number of firms produce a good, and a large number of buyers are in the market. Because so many firms are producing, there is little room for differentiation between products, and individual firms cannot affect prices because they have a low market share. There are few barriers to entry in the production of this good.
• Monopolistic Competition: A large number of firms produce a good, but the firms are able to differentiate their products. There are also few barriers to entry.
• Oligopoly: A relatively small number of firms produce a good, and each firm is able to differentiate its product from its competitors. Barriers to entry are relatively high.
• Monopoly: One firm controls the market. The barriers to entry are very high because the firm controls the entire share of the market.

The price that a firm sets is determined by the competitiveness of its industry, and the firm’s profits are judged by how well it balances costs to revenues. The more competitive the industry, the less choice the individual firm has when it sets its price.

The Bottom Line

We can analyze the economy by examining how the decisions of individuals and firms alter the types of goods that are produced. Ultimately, it is the smallest segment of the market - the consumer—who determines the course of the economy by making choices that best fit the consumer’s perception of cost and benefit.

What kind of topics does microeconomics cover?

Microeconomics is the study of human action and interaction. The most common uses of microeconomics deal with individuals and firms that trade with one another, but its methods and insights can be applied to nearly every aspect of purposeful activity. Ultimately, microeconomics is about human choices and incentives.

Most people are introduced to microeconomics through the study of scarce resources, money prices, and the supply and demand of goods and services. For example, microeconomics is used to explain why the price of a good tends to rise as its supply falls, all other things being equal. These insights have obvious implications for consumers, producers, firms and governments.

Many academic settings treat microeconomics in a narrow, model-based and quantitative manner. Traditional supply and demand curves graph the quantity of a good in the market against its price. These models attempt to isolate individual variables and determine causal relationships or at least strong correlative relationships. Economists disagree about the efficacy of these models, but they are widely used as good heuristic devices.

The basic assumptions of microeconomics as a science, however, are neither model-based nor quantitative. Rather, microeconomics argues that human actors are rational and that they use scarce resources to accomplish purposeful ends. The dynamic interaction between scarcity and choice helps economists discover what humans consider valuable. Exchange, demand, prices, profits, losses and competition arise when humans voluntarily associate with each other to achieve their separate ends. In this sense, microeconomics is best thought of as a branch of deductive logic; models and curves are simply manifestations of these deductive insights.

Microeconomics is often contrasted with macroeconomics. In this context, microeconomics focuses on individual actors, small economic units and direct consequences of rational human choice. Macroeconomics tends to study large economic units and the indirect effects of interest rates, employment, government influence and money inflation.

Economists’ Assumptions in Their Economic Models

The assumptions of economists are made to better understand consumer and business behavior when making economic decisions. There are various economic theories to help explain how an economy functions and how to maximize growth, wealth, and employment.

However, the underlying themes of many theories center on preferences, meaning what businesses and consumers prefer to have or prefer to avoid. Also, the assumptions usually involve the resources available or not available to fulfill the needs and preferences. The scarcity or abundance of resources is important in determining the choices that participants make in an economy.

Find out why economists make assumptions and how those assumptions impact economic models.

In his 1953 essay titled “The Methodology of Positive Economics,” Milton Friedman explained why economists need to make assumptions to provide useful predictions. Friedman understood economics couldn’t use the scientific method as neatly as chemistry or physics, but he still saw the scientific method as the basis. Friedman stated economists would have to rely on “uncontrolled experience rather than on controlled experiment.”

One of Milton Friedman’s most important economic contributions is the Friedman Doctrine, which states that a business’s main responsibility is to increase value for its shareholders.

The scientific method requires isolated variables and testing to prove causality. Economists can’t possibly isolate individual variables in the real world, so they make assumptions to create a model with some constancy. Of course, errors can occur, but economists in favor of the scientific method are fine with the errors provided they’re small enough or have limited impact.

Understanding the Assumptions of Economists

Each economic theory comes with its own set of assumptions that are made to explain how and why an economy functions. Those who favor classical economics assume that the economy is self-regulating and that any needs in an economy will be met by participants.

In other words, there’s no need for government intervention. People will allocate resources properly and efficiently. If there’s a need in an economy, a company will start up to fill that need creating balance. Classical economists assume that people and companies will stimulate the economy and create growth by spending and investment.

Neo-classical economists assume that people make rational decisions when purchasing or investing in the economy. Prices are determined by supply and demand while there are no outside forces impacting prices.

Consumers strive to maximize utility or their needs and wants. Maximizing utility is a key tenet of rational choice theory, which focuses on how people achieve their objectives by making rational decisions. The theory holds that people, given the information they have, will opt for choices that provide the greatest benefit and minimize any losses.

Neoclassical economists believe the propensity for consumer needs drives the economy and the business production that results to fill those needs. Any imbalances in an economy are believed to be corrected through competition, which restores equilibrium in the markets allocating resources properly.

Criticisms of Assumptions

Most critics argue that assumptions in any economic model are unrealistic and don’t hold up in the real world. In classical economics, there’s no need for government involvement. So, for example, there wouldn’t have been any money allocated to bank bailouts during the 2008 financial crisis and any stimulative measures in the Great Recession that followed.

Many economists would argue that the market wasn’t acting efficiently, and if the government hadn’t intervened, more banks and businesses would have failed, leading to higher unemployment.

The assumption in neoclassical economics that all participants behave rationally is criticized by some economists. Critics argue that there are myriad factors that impact a consumer and business that might make their choices or decisions irrational. Market corrections and bubbles, as well as income inequality, are all the result of choices made by participants that some economists would argue are irrational.

Behavioral Economics

In recent years, the examination of the psychology of economic choices and decisions has gained popularity. The study of behavioral economics accepts that irrational decisions are made sometimes and tries to explain why those choices are made and how they impact economic models.

Behavioral economists assume that people are emotional and can get distracted, thus influencing their decisions. For example, if someone wanted to lose weight, the person would study which healthy foods to eat and adjust their diet (rational decision); however, when at a restaurant, an individual sees the dessert menu, opts for the fudge cake, that is a distraction based on emotion.

Behavioral economists believe that even though people have the goal of making rational choices, outside forces and emotions can get in the way; making the choices irrational.

What Is an Example of an Economic Model?

An economic model is a hypothetical situation containing multiple variables created by economists to help understand various aspects of an economy and human behavior. One of the most famous and classical examples of an economic model is that of supply and demand. The model argues that if the supply of a product increases then its price will decrease, and vice versa. It also states that if the demand for a product increases, then its price will increase, and vice versa.

What Are Economic Assumptions?

Economic assumptions are assumptions that economists make about individuals, markets, or businesses. These assumptions are used to help predict the decisions of players in an economy and how different players use scarce resources. Assumptions can include unlimited wants, self-interest in decision-making, and rational decision-making.

How Do Economists Make Assumptions When Designing Models?

Economists make a variety of assumptions when designing models. A basic starting point for some economic models can be assuming unlimited wants and unlimited resources. Such assumptions help to better understand the decisions of individuals, such as in the economic concept of utility. The primary reason that economists make assumptions is to control variables or to exclude variables that don’t help determine predictive power.

Are Economic Models Used for Day-to-Day Pricing Decisions?

Economic models can be used for day-to-day pricing decisions. The models can help understand the reasons why a company prices its products the way it does. These models can also determine how consumers will react to these pricing decisions (demand).

The Bottom Line

Economics is a complex social science that is affected by a variety of factors. To better understand these factors, economists make assumptions in their economic models to control the model and understand a specific theory and outcome. Different branches of economics come with their own assumptions to explain how individuals and businesses use their resources.

5 Nobel Prize-Winning Economic Theories

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has been awarded 52 times to 86 Laureates who have researched and tested dozens of ground-breaking ideas.1 Here are five prize-winning economic theories with which you’ll want to be familiar. These are ideas you’re likely to hear about in news stories because they apply to major aspects of our everyday lives.

1.Managing Common Pool Resources (CPRs)

The term common pool resources (CPRs) refers to resources that aren’t owned by one particular entity. Rather, they are held by the government or are allocated to privately owned lots that are made available to the general public. CPRs (or commons as they’re commonly known) are those that are available to everyone but are in finite supply, including forests, waterways and water basins, and fishing grounds.

Ecologist Garrett Hardin wrote “The Tragedy of the Commons,” which appeared in Science in 1968. In his paper, he addressed the overpopulation of the human race in relation to these resources. Hardin surmised that everyone would act in their own best interests, meaning they would end up consuming as much as they possibly can. This would make these resources even harder to find for others.

In 2009, Indiana University political science professor Elinor Ostrom became the first woman to win the prize. She received it “for her analysis of economic governance, especially the commons.“2

Ostrom’s Groundbreaking Research

Ostrom’s research showed how groups work together to manage common resources such as water supplies, fish, lobster stocks, and pastures through collective property rights. She showed that Hardin’s prevailing tragedy of the commons theory isn’t the only possible outcome, or even most likely when people share a common resource.

Ostrom showed that CPRs can be effectively managed collectively, without government or private control, as long as those who use the resource are physically close to it and have a relationship with each other.

Because outsiders and government agencies don’t understand local conditions or norms, and lack relationships with the community, they may manage common resources poorly. By contrast, insiders with a say in resource management will self-police to ensure that all participants follow the community’s rules.

Governing the Commons: The Evolution of Institutions for Collective Action, and in her 1999 Science journal article, “Revisiting the Commons: Local Lessons, Global Challenges.

2. Behavioral Finance

Behavioral finance is a form of behavioral economics. It studies the psychological influences and biases that affect the behavior and decisions of investors as well as financial professionals. These influences and biases tend to explain various market anomalies, especially those found in the stock market. This includes very drastic increases and drops in the price of securities.

Psychologist Daniel Kahneman (Think fast and slow) was awarded the prize in 2002 “for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty.”

Kahneman’s Work

Kahneman showed that people do not always act out of rational self-interest, as the economic theory of expected utility maximization would predict. This concept is crucial to behavioral finance. The research identified common cognitive biases that cause people to use faulty reasoning to make irrational decisions. These biases include the anchoring effect, the planning fallacy, and the illusion of control.

He conducted his research with Amos Tversky, but Tversky was not eligible to receive the prize because he died in 1996.

Kahneman and Tversky’s Theory

“Prospect Theory: An Analysis of Decision Under Risk,” is one of the most frequently cited articles in economics journals. Kahneman’s (and Tversky’s) award-winning prospect theory shows how people really make decisions in uncertain situations.

They demonstrated that we tend to use irrational guidelines such as perceived fairness and loss aversion, which are based on emotions, attitudes, and memories, not logic. For example, Kahneman and Tversky observed that we expend more effort just to save a few dollars on a small purchase than to save the same amount on a large purchase.8

Kahneman and Tversky also showed that people use general rules, such as representativeness, to make judgments that contradict the laws of probability. For instance, when given the description of a woman concerned about discrimination and asked if she is more likely to be a bank teller or a bank teller who is a feminist activist, people tend to assume she is the latter even though probability laws tell us she is much more likely to be the former.

3. Asymmetric Information

This discipline is also known as information failure. It occurs when one party involved in an economic transaction has much more knowledge than the other. This phenomenon typically presents itself when the seller of a good or service possesses greater knowledge than the buyer. But in some cases, the reverse dynamic may also be possible. Almost all economic transactions involve asymmetric information.

In 2001, George A. Akerlof, A. Michael Spence, and Joseph E. Stiglitz won the prize “for their analyses of markets with asymmetric information.“9 The trio showed that economic models predicated on perfect information are often misguided. That’s because one party often has superior information in a transaction.

Understanding information asymmetry has improved our knowledge of how various markets work and the importance of corporate transparency. Today, these concepts are so widespread that we take them for granted, but when they were first developed, they were groundbreaking.

Akerlof, Spence, and Stiglitz’s Research

Akerlof showed how information asymmetries in the used car market, where sellers know more than buyers about the quality of their vehicles, can create a market with lemons (a concept known as “adverse selection”). A key publication related to this prize is Akerlof’s 1970 journal article, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.

Spence’s research focused on signaling or how better-informed market participants can transmit information to lesser-informed participants. He showed how job applicants can use educational attainment as a signal to prospective employers about their likely productivity and how corporations can signal their profitability to investors by issuing dividends.

Stiglitz showed how insurance companies can learn which customers present a greater risk of incurring high expenses. He called this process screening. According to Stiglitz, asymmetric information occurs by offering different combinations of deductibles and premiums.

4. Game Theory

The theory of non-cooperative games is a branch of the analysis of strategic interaction commonly known as game theory. Non-cooperative games are those in which participants make non-binding agreements. Each participant bases his or her decisions on how he or she expects other participants to behave, without knowing how they will actually behave.

The academy awarded the 1994 prize to John C. Harsanyi, John F. Nash Jr., and Reinhard Selten “for their pioneering analysis of equilibria in the theory of non-cooperative games.

Harsanyi, Nash, and Selten’s Analysis

One of Nash’s major contributions was the Nash Equilibrium, a method for predicting the outcome of non-cooperative games based on equilibrium. Nash’s 1950 doctoral dissertation, “Non-Cooperative Games,” details his theory. The Nash Equilibrium expanded upon earlier research on two-player, zero-sum games.

Selten applied Nash’s findings to dynamic strategic interactions, and Harsanyi applied them to scenarios with incomplete information to help develop the field of information economics. Their contributions are widely used in economics, such as in the analysis of oligopoly and the theory of industrial organization, and have inspired new fields of research.

5. Public Choice Theory

This theory attempts to provide the rationale behind public decisions. This involves the participation of the general public, elected officials, political committees, along with the bureaucracy that is set up by society. James M. Buchanan Jr. developed the public choice theory with Gordon Tullock.12

James M. Buchanan Jr. received the prize in 1986 “for his development of the contractual and constitutional bases for the theory of economic and political decision-making.“13

Buchanan’s Award-Winning Theory

Buchanan’s major contributions to public choice theory bring together insights from political science and economics to explain how public-sector actors (e.g., politicians and bureaucrats) make decisions. He showed, contrary to the conventional wisdom, the following:

• Public sector actors act in the public’s best interest (as public servants).
• Politicians and bureaucrats tend to act in their own self-interest, the same way private sector actors (consumers and entrepreneurs) do.

He described his theory as “politics without romance.” Buchanan laid out his award-winning theory in a book he co-authored with Gordon Tullock in 1962, The Calculus of Consent: Logical Foundations of Constitutional Democracy.13

We can get a better understanding of the incentives that motivate political actors and better predict the results of political decision-making using Buchanan’s insights about the political process, human nature, and free markets. We can then design fixed rules that are more likely to lead to desirable outcomes.

For example, instead of allowing deficit spending, which political leaders are motivated to engage in because each program the government funds earns politicians support from a group of voters, we can impose a constitutional restraint on government spending, which benefits the general public by limiting the tax burden.

Honorable Mention: Black-Scholes Theorem

Robert Merton and Myron Scholes won the 1997 Nobel Prize in economics for the Black-Scholes theorem, a key concept in modern financial theory that is commonly used for valuing European options and employee stock options.14

Though the formula is complicated, investors can use an online options calculator to get its results by inputting an option’s strike price, the underlying stock’s price, the option’s time to expiration, its volatility, and the market’s risk-free interest rate. Fischer Black also contributed to the theorem, but could not receive the prize because he passed away in 1995.

The Bottom Line

Each of the dozens of winners of the Nobel memorial prize in economics has made outstanding contributions to the field, and the other award-winning theories are worth getting to know, too. Working knowledge of the theories described here, however, will help you establish yourself as someone who is in touch with the economic concepts that are essential to our lives today.