Microeconomics (Encyclopedia of Business and Finance)
Microeconomics (Encyclopedia of Business)
Microeconomics, or price theory, covers the economic activity of individual consumers or producers or groups of consumers and producers, and the markets in which they interact. Therefore, microeconomics is the study of buyers, sellers, prices, profits, and wages. The field is devoted to the examination of choices and motivations of these individual economic elements. In contrast, macroeconomics covers the economic activity of entire populations, or aggregates, of consumers and producers.
Nevertheless, the distinction between microeconomics and macroeconomics is somewhat artificial. While macroeconomics traditionally has addressed economic issues such as inflation and unemployment, current economic thought attributes inflation just as much to microeconomic factors as to macroeconomic factors.
Traditionally, the supply and demand model serves as the foundation of microeconomics, along with a basic set of interrelated principles, including markets, competition, production, cost, and distribution. Together, these principles account for microeconomic phenomena such as price changes, profit margins, and wage differences.
The terms microeconomics and macroeconomics have their origin in the early 1930s, when economists strove to gain an understanding of factors that created the Great Depression. Separate mechanisms to describe the actions of individuals and aggregate populations were first described by the Norwegian economist Ragnar Frisch (1895-1973) in 1933.
Frisch called these mechanisms "microdynamic" and "macro-dynamic." He wrote that micro-dynamic analysis seeks to "explain in some detail the behavior of a certain section of the huge economic mechanism" within specific parameters, while macro-dynamics gives "an account of the whole economic system taken in its entirety."
John Maynard Keynes (1883-1946), in his seminal 1936 publication The General Theory of Employment, Interest, and Money, established a popular scientific basis for the separate analysis of micro- and macro-dynamic activity. Economists adopted many of Keynes's assumptions about equilibrium, assumptions required to make the models simple enough to work, and subsequently developed these separate methodologies into often unresolvably dissimilar sciences.
The Dutch economist Peter de Wolff was the first to publish the term "micro-economics" in a 1941 article on the income elasticity of demand. Others began using the term in their own works, and by the late 1950s microeconomics and macroeconomics made their way into textbooks. Thus, the division of analysis along two different lines of assumptions about the market was institutionalized as a central feature of the study of economic systems.
THE MARKET ECONOMY
Market economy refers to the developed, industrialized economies found throughout most of the world, in which people specialize in the production of a limited array of goods or services and meet their food and material needs through exchange. In market economies, because of specialization and agricultural advances, farmers can produce far more agricultural products than they need, which allows them to sell the surplus to others, who consequently do not have to produce food of their own. Instead, the rest of the population can specialize in other goods, or in services. Hence, farmers, for example, can trade agricultural products for furniture and clothing made by people who specialize in these products and vice versa. While early exchanges were done with barterrading corn for clothes, for instanceontemporary exchanges are done with money, which facilitates trade in that farmers with corn do not have to find clothing makers seeking corn in order to obtain clothing.
SUPPLY AND DEMAND
Some of the central questions of microeconomics are why certain products or servicesommoditiesost more than others and why prices change. In order to answer these questions, economists developed the model of supply and demand. Commodities, which include cars, clothing, food, and gas, are scarce relative to their uses. Commodities have prices because they are both useful and scarce. For example, although air is useful, it is not scarce and hence is free. In contrast, corn is both scarce and useful. In economics, usefulness and scarcity take the form of demand and supply, respectively, since consumers demand commodities because they are useful and merchants cannot supply infinite quantities of commodities because they are scarce. Therefore, market prices result from the relationship between supply and demand.
As a result, a commodity that is very scarce will cost far more than a commodity that is not as scarce, because consumers will be willing to pay more money given the small supply. In most cases, however, when a commodity's price is high, demand will fall, because consumers will meet their needs with alternative products. For example, if the lettuce crop is small because of frost damage and the price of lettuce is high, consumers will buy less lettuce and more cabbage, assuming it has a lower price. In other words, if supply exceeds demand prices decrease and if demand exceeds supply prices will increase.
Equilibrium refers to the effect of the economic forces supply and demand in balancing each other's influence so that there is no tendency for change. The price of a commodity will be in equilibrium if the quantity demanded equals the quantity supplied; that is, if the amount of a commodity consumers are willing to buy equals the amount sellers are willing to supply. Economists call the price in such a scenario the "equilibrium price" and the quantity the "equilibrium quantity." At the equilibrium price, buyers and sellers can trade as much of a commodity as they want.
If the price is not in equilibrium, however, quantity demanded will not equal the quantity supplied. If the price rises above the equilibrium price, consumers will buy less of a commodity than they would at the equilibrium price, and so supply would exceed demand. Consequently, there would be a surplus or excess supply. Conversely, if the price falls below the equilibrium price, the consumers will buy more of a commodity than would they would at the equilibrium price, and so demand would exceed supply. Consequently, there would be a shortage or excess demand.
SHORT-RUN AND LONG-RUN SCENARIOS.
Supply and demand are not static; they will change over time. For that reason, microeconomists use two time frames for their considerations, the short run and the long run. Short-run scenarios assume no movement in supply or demand because the time frame involved is too brief to allow sellers to alter their supply and for consumers to change their demand.
In the long run, however, sellers and consumers may exercise changes in supply and demand: sellers by offering more or less of a product to maximize profit, and consumers by reacting to these changes in supply.
The common denominator for both sellers and consumers is the price mechanism. Excess demand in the short run yields high profits, inspiring greater supply in the long run. This increases the supply and dries up excess demand, forcing prices down and lowering the margin of profit.
THE PRICE ELASTICITY OF DEMAND.
As previously illustrated, the quantity demanded rises with a commodity's price falls and vice versa. Consequently, the quantity demanded is responsive or sensitive to price changes. Nevertheless, some commodities are more responsive to price changes than others, depending on the availability of alternatives, the necessity of the commodity, and the percentage of a consumer's income spent on the commodity. For example, as Miltiades Chacholiades points out in Microeconomics, consumption of salt is not very responsive to prices changes, because there is no direct substitute and because consumers spend only small percentage of their incomes on salt.
Consequently, businesses and governments must take into account the responsiveness of demand to price changes in order to plan budgets and strategies prudently. For example, a store cannot raise its prices arbitrarily without considering how many customers it will lose to competitors because of the price increases.
Economists measure the degree of responsiveness in demand for a commodity to price changes by using the concept of the price elasticity of demand, which is also called the elasticity of demand or just demand elasticity. Economists define this concept as:
PRICE ELASTICITY OF SUPPLY.
The quantity suppliedhe total quantity of a commodity merchants are willing to selltems from a commodity's price. The price elasticity of supply measures the responsiveness of the quantity supplied to prices changes. Economists calculate the degree of responsiveness in a quantity supplied to price changes using the following equation:
MARKETS AND COMPETITION
Since microeconomics generally involves capitalist economies, economists study the role competition plays in supply and demand. Competition manifests itself in markets differently and therefore has different effects in different markets. One of the most important markets is the perfectly competitive market, which refers to a market where there are many sellers offering the exact same goods, where all buyers know the price of every seller, and where there are no barriers to entry. As a result, all sellers offer their goods at the same price. Since all the buyers know the sellers' prices, they would buy the goods from the cheapest seller if the prices were not the same.
Moreover, the perfectly competitive market prohibits any seller from earning an extraordinarily high profit. If the goods were extremely profitable, then many new sellers would enter the market, since there are no barriers to entry. Presumably, the new sellers would keep prices low to attract customers and these efforts would cause established sellers to lower their prices to compete, driving profits down to a normal level.
On the other hand, a seller that is alone in a market with no competitors is a monopoly. Monopolies exist because they own proprietary rights to their product (for example, a pharmaceutical company with a patented drug formula), because competition would raise average costs in the industry (such as with electrical power distribution), or because there are significant barriers to entry.
A monopoly will determine a price based on demand elasticity. In other words, it would lower its price only if that would increase its total revenues. For example, electricity is very nearly a necessity in daily life. The utilities that provide it operate in a natural monopoly (where competition could only raise costs, rather than lower them). If they were allowed to set a high price for electricity, demand might drop only slightly. For this reason, governments have created regulatory agencies not only to police monopolies' costs but also to set their prices at affordable levels.
Somewhere between competition and monopoly is monopolistic competition, where several firms compete in the same market, but with appreciably unique products. For example in the pharmaceutical industry, a number of companies may produce different drugs that combat the same affliction. But each may work better for certain types of patients, affording its maker a monopoly in limited areas of the wider market.
Another type of market is the oligopoly, where a small number of firms dominate the market, operating with quasi-monopolistic power. The automobile, appliance, aircraft, and steel industries, among others, fall into this category. While competition may exist and even be intense in oligopolies, governments have enacted antitrust acts and laws to prevent them from price fixing.
The demand side of the supply and demand equation is influenced by consumption and consumers. In economics, consumers can refer to both individuals and households. For example, automobile purchases are usually analyzed on a household basis, whereas restaurant purchases are usually analyzed on an individual basis. Economists study consumer spending habits and patterns, because consumer tastes and preferences help determine the demand for various commodities. Microeconomics relies on three assumptions about consumers:
- Consumers may prefer commodity A over commodity B, may prefer commodity B over A, or may be indifferent and have no preference.
- Consumers' preferences are transitive, meaning if consumers prefer commodity A over B and commodity B over C, then they prefer commodity A over C.
- Consumers prefer more of a commodity than less.
Using these assumptions, economists plot out consumer preferences on graphs or indifference maps to represent how consumers rank various commodities or groups of commodities. In addition, economists attach numbers or utilities to these commodities to reflect their levels of preference by consumers. This approach to analyzing and representing consumer preferences enables economists to determine consumer preferences by glancing at their numbers or utilities. For example, if commodity A has a higher number or utility than commodity B, consumers will prefer commodity A over B.
But consumer preferences are only half the picture. Economists assume that consumers strive to maximize the utility of their purchases. Consequently, commodity prices and consumer income also come into play, since both factors will influence the kinds of commodities a consumer will buy. Economists call the amount of money a consumer has to spend in a specific period of time, such as a month, "money income." Hence, the higher the commodity price, the smaller the quantity a consumer can purchase, regardless of consumer preferences.
PRODUCTION AND COST
Identifying consumer preferences and discussing the effects of consumer income levels provides an overview of the demand-side factors. In contrast, discussing issues related to production and cost provides an overview of the supply-side factors. The commodities desired and supplied result from production of some sort, whether it is manufacturing, recording, printing, farming, teaching, writing, or any number of other forms of production. Firms take inputs of raw materials and convert them into outputs of products and services. The production process includes not only the actual creation of the commodities, but also the storage and transportation of them.
The production process generally involves a variety of inputs or production factors, which economists divide into four categories: labor services, capital goods, land, and managerial skills. Labor services are provided by a plethora of different kinds of workers including construction workers, doctors, farmers, lawyers, plumbers, teachers, and writers. Capital goods refer to the equipment, goods, and other materials companies use to make their end products and include buses, trucks, machinery, tools, wood, fuel, and grain. While all firms need land to some extent, some enterprises such as farming and mining require land with specific characteristics such as fertility and the presence of mineral deposits, respectively. Finally, the production process must have people or groups of people to provide a firm with coordination, leadership, strategy, and supervision.
Economists assume that firms attempt to coordinate the factors of production so that they can generate commodities as efficiently as possible, which will enable them to maximize their profits. In addition, economists use the concept of the "production function" to indicate a firm's technical capability. A firm's production function refers to its ability to produce its commodities efficiently and covers the relationship between labor and capital goods for a given unit of time, for example.
The other part of the supply side is cost. Simply put, the amount paid for all the inputs such as labor, land, and materials a firm needs to produce a specific output is the "total cost." Total cost includes total fixed cost and total variable cost. Total fixed cost remains the same no matter if 10 units are produced or 10,000. On the other hand, total variable cost fluctuates with the level of production, increasing with greater production and decreasing with less production. Firms choose methods of production that maximize the cost efficiency of the inputs; that is, they seek the method of production with the lowest total cost to produce a certain output specific quantity of a commodity. Firms achieve this efficiency by calculating their revenues at various levels of output at minimal total costs and choosing the level of output at which revenues exceed total cost the most.
Economists examine distribution in order to explain how the prices for the factors of production are established. Therefore, distribution covers the payment of wages for labor services as well as the rent paid for land and capital goods. Just as supply and demand determine commodity prices, so they also determine prices of the factors of production. For example, the supply of nuclear physicists is scarce relative to the demand, and so nuclear physicists can earn high wages in the labor market. In contrast, unskilled general laborers are not nearly as scarce; hence, they earn far lower wages. A number of factors determine the supply and hence the wage differences for various job including education, training, experience, and market structure (e.g. union versus nonunion jobs). In addition, state and federal laws also influence the cost of labor services. For example, the federal minimum wage guarantees that workers receive at least the federally mandated minimum hourly wage. Supply and demand also determine levels of employment: unemployment is high when demand for workers is low.
The cost of capital goods such as raw materials, industrial equipment, tools, and fuel also are set by supply and demand factors, similar to those that determine commodity prices paid by consumers.
Businesses usually use the factors of production indirectly; that is, the demand for the factors of production is derived demand. Businesses generally do not simply hire workers and buy raw materials for their own sake. Instead, they hire workers and buy raw materials to produce goods, which they will sell for profit. For example, the demand of butchers stems from the demand for meat. Hence, payment for the factors of production depends on what is being produced.
updated by Karl Heil]
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