Microeconomic theory prepares individuals for analyzing demand, supply, and equilibrium under certain assumptions. A study of economic theory involves recognizing explicit forms of assumptions and elevating our sensitivity to other assumptions encountered in our daily pursuits at work, play, and/or study. Far beyond the simplicities afforded by assumptions, however, are the Law of Demand and the Law of Supply. As the reader of this essay will see, both laws inform us of a specific relationship between price and quantity. More importantly, supply and demand when taken together help describe equilibrium and portray the dynamics between equilibrium price and quantity. This essay attempts to convey a vast array of concepts, models, and views that undergraduate students will encounter in a study of microeconomics. The essay also recognizes some obstacles to learning that students are likely to encounter during their studies of the discipline.
Keywords: Demand; Determinants; Equilibrium; Opportunity cost; Price; Quantity; Scarcity; Supply; Utility
Microeconomic theory provides a conceptual foundation for analyzing demand, supply, and equilibrium in addition to other interrelated topics. Let us begin with a brief overview of how those concepts fit together from within an overarching theoretical framework. Consider first that theory is a mental abstraction consisting of a set of principles, methods, and models. In general, those models of economic theory and behavior contain an array of variables and interrelationships. In essence, variables and relationships set forth by a theory help us to simplify reality by breaking it down into manageable pieces and by subscribing to some key underlying assumptions.
A discussion of assumptions will follow in the section ahead. Models present us with a framework for organizing key pieces of information. Keep in mind that a model, moreover, is a tool that enables us to simplify reality and to summarize key hypotheses and relationships. Theories provide a basis with which to formulate those hypotheses. By nature, hypotheses convey information about what we can expect to observe in terms of how one or more variables relate to a key variable in accordance with theory. Scientists and researchers use theories and test hypotheses in order to generate knowledge and information from a limited amount of data. Some hypothesized relationships become truths after a long period of confirmation and/or of acceptance by a profession; eventually, they become laws. Two laws central to the study of microeconomic theory are the Law of Supply and the Law of Demand, which will receive ample attention in the text ahead.
Textbooks also devote a considerable amount of content to these two laws, expanding them into several hundred pages on demand and supply. Readers of this essay will find references to economics textbooks for which the essay author is most familiar (Arnold, 2005; Guell, 2009; McConnell & Brue, 2008) given their use in introductory courses. The reader of this essay may find benefit in knowing that the first eight or so chapters of most principles of economics textbooks provide a firm foundation for the study the economic theory. Specifically, Issues in Economics Today, the text book authored by Guell, is a valuable resource to any introductory level course in economics; particularly those courses designated for the non-business major or individuals in the major exploration phase of their academic pursuits.
Guell (2009) defines microeconomics as "[t]hat part of the discipline of economics that deals with individual markets and firms." This essay, which takes the form of a scholarly application and integration of theory, extends that definition and describes how individuals and firms create and interact in markets. Consider another yet deeper, perhaps more salient description of microeconomics, as found in Pearce (1992, pp. 276-277). According to Pearce, the term microeconomics is engaged to "describe those parts of economic analysis whose concern is the behaviour of individual units, in particular, consumers and firms" and that analysis "of individual behaviour concentrates on consumer demand theory" and "analysis of firm behaviour concentrates on production decisions and price theory." In other words, theories of consumer demand and prices coupled with analyses of individual and firm behavior comprise microeconomic theory.
The reader should have a sense by now that consumers and firms are two groups about which we can offer some generalizations. Microeconomic theory comprises a theory on consumers and a theory on firms from which we can simplify reality and deal with most of its complexities. In addition, the reader should be mindful that economic models consist of three highly interactive components: Consumers, businesses, and markets. The next section begins with a set of assumptions that are necessary in covering and learning economics.
Assumptions are sometimes implicit and at other times are explicit; elevating sensitivity to either form is beneficial in a life of work, play, and study. A number of assumptions are applicable to an in-depth study of economics. Foremost among those three assumptions is the ceteris paribus assumption. Its literal translation from Latin into English means "all else is held constant." Anyone examining economics will discover that a wide array of relationships exists, which makes it necessary to consider as few as possible.
Next is the assumption in microeconomic theory that individuals (primarily consumers and producers) behave rationally and choose to maximize their own self-interest. As strange as this may sound, those behaviors and choices serve a major function in the betterment of society according to an economics perspective. This second assumption means that consumers and producers have full and immediate access to perfect information relevant to their decisions.
A third assumption is that those agents engage in transactions through which no individual or group brings an inordinate amount of influence to an exchange decision. In essence, this assumption carries the notion that an exchange between a buyer and a seller yields benefits and/or costs to them whereby third parties incur the same set of benefits and/or costs. Actions of individuals can affect larger society whether in a good or a bad manner; for the sake of brevity, this author invites those who want to learn more about that societal dimension to explore topics such as welfare economics and macroeconomics by considering the entries found in the suggested readings list near the end of this essay.
The Economic Problem
The aforementioned assumptions enable us to study economics and to recognize some key tenets of an economic perspective on the world with which we interact. Economics is all about scarcity. In terms of our own behaviors, most of us truly have unlimited wants and face limited resources. Our attempt to reconcile between those wants and resources gives rise to a major problem: The economic problem. A reason for studying economics is to alleviate that problem.
Scarcity forces us to make choices and each decision presents us with a trade off or an opportunity cost. We can measure the value of our decisions in terms of the value of the forgone alternative. For example, the opportunity cost of reading this essay is the value you place on whatever it is that you might prefer to be doing when it is the next best alternative to reading this essay. Economic valuations of opportunity costs help consumers to decide how to allocate scarce resources (time, money, etc.). Likewise, business owners and entrepreneurs usually have a minimum profit rate in mind for the enterprise they operate, which typically coincides with that for the industry in question. If the actual profit rate fails to meet expectations, those operators can choose another industry where they can pursue whatever may be considered a normal rate of profit.
By extension, the costs of conducting business include the normal rate of profit. This means that an enterprise must receive a price for their goods and services that covers profit and explicit costs. Price needs to become an agreement between a seller and a buyer of those goods and services. The seller or supplier will provide some amount at each price within a given range of prices and the buyer or consumer will purchase some amount at each price within a given range. In essence, price is a mechanism that is said to clear the market because buyers and sellers arrive at a price for which is agreeable between them.
Let us begin with the demand or consumer side of the situation. This article and many economists subscribe to the view that a good or service becomes available because of consumer demand. In brief, suppliers provide and offer goods and services, but the consumer ultimately decides whether to pay the asking price. The next two sections describe the relationships between prices and quantities beginning with the demand side and ending with the supply side.
The Law of Demand
The Law of Demand informs us that an inverse or negative relationship exists between price and quantity demanded. In other words, consumers demand less (more) of a good or service when its price rises (falls). Individual demand schedules are estimates of how many units of that good or service a specific consumer is willing and able to purchase over a period at a given price. On a...
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