Microeconomics & Public Policy
This essay provides a frame of reference for objective approaches to complex political and legal public policy environments typically found within a market-system context. In contrast to other economic systems, the market-system orientation of the United States' economy subscribes to and protects the notion of free enterprise. This essay covers two intertwined theories, microeconomic theory and public-interest theory of regulation. With its focus on firm and consumer behaviors, microeconomic theory encompasses production decisions and determinations of price, output, and profit levels and presents a foundation for crafting and analyzing public policies. Public-interest theory of regulation contends that the need for regulation arises in order to protect the consuming public from abuses by producers. Antirust, industrial, and social regulations demonstrate the value of microeconomic theory to public policy. The essay introduces an array of methods and ideologies that economic analysts employ.
Keywords Ceteris Paribus; Concentration Ratio; Conglomerate Merger; Demand Schedule; Demand; Economic Profit; Economic systems; Elastic; Externalities; Fixed Costs; Horizontal Merger; Inelastic; Law of Demand; Law of Supply; Marginal Revenue; Market Failure; Market system; Market; Microeconomic theory; Monopoly; Natural Monopoly; Normal Profit; Output; Perfect Competition; Predatory Pricing; Price; Price Controls; Price Elasticity of Demand; Price Fixing; Producers; Profit; Public interest theory of regulation; Public policy; Revenue; Supply; Variable Costs
The information presented in this essay provides a frame of reference within which to describe the perpetual need for economists and other social scientists to lend objective mindsets to complex political and legal public-policy environments. Though this essay provides a foundation for developing future analysts and effective navigators who can moderate these environments, its main purpose is to help undergraduate students and other readers develop their knowledge of economic theory, demonstrate their understanding of its relevance to public policy, and apply their skills in serving the public interest. In general, this essay will generate a better understanding of the interdependent relationships between market economics, industrial and social regulation, and government policy. More specifically, it will convey information about the role of the federal government in encouraging industrial stability, protecting citizens' well-being, and maintaining competitive exchanges of goods, services, and scarce resources.
In contrast to a command- or a plan-based economic system, in which the government or a few powerful individuals determine the nature and scope of domestic economic activity, the market system that the United States operates is built upon the notion of free enterprise. Though some flaws exist in this system, its essence merely requires voluntary involvement between those who pay a price in exchange for goods and services that bring satisfaction and those who incur costs and earn profits while providing the goods and services that satisfy the other party's needs and wants. In other words, consumers and producers come together in product markets to exchange dollars for goods and vice versa. Those markets often vary to some extent in terms of the degree and nature of competition between and among producers. Perfect competition, as a reference point, is analogous to an auction-house scenario and is a natural element in a market-based system. In essence, the general intent of public policy in terms of microeconomics is to manage the level of competition. The government laws and policies covered in this essay include protecting vulnerable industries, moderating noncompetitive prices, and addressing market power.
This essay conveys the tenets of two intertwined theories. One is microeconomic theory, which will be discussed below in detail before we turn our attention to its applications to public policy. Public-interest theory of regulation presents the notion that industrial regulations protect the consuming public from abuses by producers who hold market power (McConnell & Brue, 2008). Market power usually occurs whenever a few firms are the dominant suppliers of a product, whether by design or by coincidence. Electric power, natural gas, and communication companies serve as examples of natural monopolies. Like any monopoly, market power accrues because rival firm entry is nearly impossible and profit maximization occurs at a low level of output, resulting in costs and prices that are higher relative to firms operating in highly competitive markets. Consistent with this theory, the imposition of regulations benefits consumers through reduced costs and higher outputs while allowing producers to cover production costs and earn a fair return. We will return to this perspective and its application, but first we need to cover microeconomic theory and gain an understanding of its relevance.
Microeconomic Theory: A Perspective on Markets, Behaviors,
With its focus on firm and consumer behavior, microeconomic theory focuses partially on production decisions and price derivations. On the one hand, firm behavior analyses focus on production decisions and pricing, usually with an eye toward the type of market in which the firm supplies an item. Microeconomic theory also focuses on analyses of individual behavior and market demand for an item.
Studies in microeconomics usually begin by accepting a set of assumptions, which forms the parameters for additional inquiry.
- First and foremost is the ceteris paribus (all else is held constant) assumption.
- The second assumption is that consumers and producers behave as rational agents who have access to full, perfect information relevant to their decisions.
- A third assumption is that when those agents engage in transactions, no individual or group brings an inordinate amount of influence to an exchange decision.
- The fourth and last assumption of interest here is that item prices reflect only the direct private value of an exchange between a buyer and a seller; in other words, the system of exchange omits or ignores the indirect benefits or costs incurred by other members of larger society.
Problems arise in the marketplace when any of the last three assumptions become unrealistic or fail to hold true. Policy analysts and economists refer to such a situation as a market failure. Its occurrence may establish a rationale for governmental intervention, such as the formation and implementation of public policies; for more information on these and other concepts found in this essay, consult the economics dictionary as edited by Pearce (1992).
In addition to learning about market failures and public policies, students of microeconomics often begin by focusing their attention on relationships between the possible prices of an item, the quantities consumers are willing and able to purchase at each price, and the quantities suppliers are willing and able to produce.
On the consumer or demand side, an inverse relationship exists between price and quantity in accordance with the law of demand. Relatively speaking, smaller amounts are in demand at higher prices and vice versa.
Prices generally reflect an agreement between sellers and buyers, who exchange goods and services as they interact in the marketplace. Most sellers take the price dictated by market forces, and very few sellers are able to set the market price. In terms of demand, typically the higher the price for any item, the more sensitive consumer purchases become. Elasticity is a concept that measures consumer sensitivity to price hikes. Calculations of the price elasticity of demand allow economists to determine precisely, in percentage terms, how much a consumer's purchases of an item will decrease in response to an increase in its price. Guell (2007, p. 41) summarizes a few studies on the price elasticity of demand; for instance, the evidence with respect to airline travel informs us that any given 10 percent increase in the airfare will result in an 18 percent decrease in the number of tickets sold. Keep in mind that the ratio varies according to whether the travel is for business or leisure and that business travelers are less responsive to price hikes than leisure travelers. We will return to this concept and the questionable practice of segmenting a market according buyers' price elasticity of demand.
On the producer or supply side, a positive relationship exists according to the law of supply. The price at which producers can sell their goods and services is only one constraint. The relationship between market prices and producer costs often influences whether item production will occur. Firms incur a variety of costs in their production of goods and services. The following sections provide a short discussion and description of those costs and some direction regarding their applicability to public policy and analysis.
Total costs are the sum of fixed and variable costs. Fixed costs are those that exist even without any production and do not vary with the scale of production. Some examples of fixed costs are monthly fees paid for machinery, buildings, and land. Variable costs are those that vary with production. Some examples of variable costs are wages, materials, and supplies.
The allocation of costs across larger scales of production results in a variety of cost curve shapes. Graphs depicting these functions show cost on the vertical axis and quantity on the horizontal axis. Average total cost and average variable cost form important U-shaped curves. Their calculation involves dividing them by the production quantity. The lowest points on those curves are significant. At those points is where the marginal cost curve, which is J-shaped, intersects them. Marginal cost is the change in total costs that arises from producing one additional unit.
Firms produce and sell items, and they receive a price for each one sold. Total revenue is the mathematical product of price times the quantity sold at each price. Marginal revenue is the change in total revenue that arises from selling one additional unit. Price is equal to marginal revenue in competitive market structures and greater than marginal revenue in monopolistic market structures. Though graphs can become quite confusing with each addition of a line or curve, keep in mind that the marginal revenue line is horizontal in perfectly competitive market structures and downward sloping in monopolistic structures.
A key relationship exists where marginal revenue equals marginal cost and where these two curves intersect. The intersection determines the profit-maximizing amount of output. Most, if not all, firms attempt to set production to that amount as they exhibit profit-maximizing behaviors. Now, let us bring prices back into the analysis for a short discussion of the rules of production. These rules help gauge whether a firm may continue its operation as a competitive, viable entity.
Rules of Production
To comply with the first of two rules, firms must produce at the profit-maximizing output, which is, again, where marginal revenue equals marginal cost. The second rule is that firms must receive a price that is equal to or greater than average variable cost. Their sales must cover, at the least, average variable costs and contribute something toward average fixed costs. In other words, they must cover their...
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