Microeconomics is a subset of economics that focuses on the actions of individual participants in the economy, including individual consumers and businesses.
Unlike macroeconomics, which focuses on understanding and modeling collective behavior, microeconomics is the study of the decision-making process of individual entities within an economy. The branch of microeconomics that focuses on the consumption of individual households is called consumer theory, and the branch that covers the production of firms is called producer theory. According to microeconomic theory, consumers act to maximize the utility of the goods and services they buy, while producers act to maximize profits.
Microeconomics is mainly based on the model of supply and demand. The supply and demand model is simply a measure of how many goods and services producers are willing to produce and sell at different prices and how much consumers are willing to buy at those same prices. . Supply, demand and price are three key variables in economics.
Demand is the quantity of a good or service that consumers are willing or able to buy at a given price. Similarly, supply is the quantity of a good or service that a producer is willing or able to sell at a given price. According to the law of supply and demand, the demand for a commodity varies inversely with its price if all other factors are consistent. In other words, the higher the price of a commodity, the lower the demand.
By plotting supply and demand curves for a good or service at different price levels, economists can predict how an individual consumer or producer will react to a particular set of economic circumstances. The price at which the supply curve intersects the demand curve represents the equilibrium price and the equilibrium quantity. Changing economic conditions may move the market away from this theoretical equilibrium point, but individual actors within the economy will act to bring the market back towards the equilibrium point by increasing and decreasing production and consumption.
Macroeconomics is the study of the economy as a whole, including major factors such as employment, gross domestic product, and inflation. Microeconomics focuses on particular markets and individual actors within those markets, including the interactions between supply and demand for specific goods and services.
Macroeconomic studies tend to focus on a specific country, region, or government. Microeconomic studies generally target particular industries or markets, such as the automotive market, the oil and gas industry, or the travel industry.
There are at least seven general principles of economics that are central to microeconomic analysis.
- Supply and demand. Price, supply and demand are all linked, and consumers and producers will behave in ways that bring these factors into balance.
- Opportunity cost. Consumers have limited resources and unlimited choices of how to spend their money. Opportunity cost is the cost associated with a consumer spending money in a way that is not optimal. In other words, when a consumer purchases a particular good or service, all other mutually exclusive purchases that the consumer has chosen not to make represent the opportunity cost, often described as the cost of loss.
- Law of diminishing marginal utility. This law states that the more a consumer buys a product or service at a time, the less demand there will be for the same product or service. For example, a hungry consumer may pay $50 for a 16-ounce steak in a restaurant, but is unlikely to be willing to pay for a second steak at the same price on the same night.
- Giffen goods. Giffen products are non-luxury items, such as bread, wheat, and gasoline, for which demand tends to increase as prices rise.
- Veblen goods. Veblen products are luxury items considered symbols of socioeconomic status, such as sports cars, jewelry, and yachts, for which demand tends to rise as prices rise.
- Income and elasticity. Elasticity measures the change in demand for a product or service when its price changes. There is a positive correlation between a consumer’s income and the demand for higher quality goods and services.
- Substitution and elasticity. When the price of a good or service becomes so high that consumers can no longer afford it, they will often buy a cheaper alternative.
The principles of microeconomics can be applied to understand budget decisions and common financial situations of households or businesses. Homebuyers comparing interest rates on home loans, an individual buyer choosing one brand or product over another, a company investing in capital equipment to grow its business, and two companies competing for customers on the same market are all examples of situations that can be studied and modelled. based on microeconomic principles.
Economists also use microeconomic principles to predict how demand for a product or service will be affected by a change in price or how much a firm may reduce output as input costs rise.
Nobel laureate and Norwegian economist Ragnar Frisch first discussed “micro-dynamic” and “macro-dynamic” economic analysis in 1933. In 1942, economist Joseph Alois Schumpeter proposed the idea of creative destruction, declaring that old and obsolete products and companies will be replaced by newer ones. In 1957, economist Gary S. Becker published groundbreaking microeconomic analysis suggesting that discrimination against minority groups is economically detrimental to the majority group. Other famous microeconomic thinkers include Alfred Marshall, Ronald Coase, Elinor Ostrom, William Vickrey, George Akerlof, Joseph Stiglitz, William Baumol, and Arthur Cecil Pigou.
Microeconomics is important for investors when deciding where to put their money. Macroeconomic factors such as rising interest rates or falling GDP can drive down the valuations of most stocks in the market. However, the relative valuations of different sectors of the market and of different stocks within the same sector or industry are often dictated by microeconomic principles. For example, the war in Ukraine disrupted the global supply of Russian oil, leading to higher US oil prices and a spike in oil inventories – even as much of the rest of the stock market fell.
- Granularity. Unlike macroeconomics, microeconomics offers investors and economists a more detailed and nuanced understanding of what is happening in the economy at the sector, industry, or firm level. By understanding the decisions of individual consumers and producers, economists can extrapolate this behavior to model changing economic dynamics on a much larger scale.
- Business decision making. Businesses use microeconomics to make decisions about what products or services to produce, what prices to charge, and how much to produce.
- Consumer research. Consciously or unconsciously, consumers use the principles of microeconomics to balance their budget or even choose the products and brands they buy at the grocery store.
- Assumed rationality. Some of the theories of microeconomics assume that producers and consumers are rational actors, but sometimes they act irrationally. During times of market bubbles and panics, prices and demand can skyrocket or crash based more on psychology and emotion than changes in supply.
- Assumed efficiency. Microeconomic principles also assume that a market is efficient, which is not always the case. In a monopoly, for example, one entity controls all market supply and can set artificially high prices regardless of supply and demand.
- Narrow focus. For investors, focusing too much on the microeconomics of a company or industry can lead to blind spots when it comes to the big picture. A company may have the best microeconomic metrics within its industry, but its stock price will likely decline further if a deteriorating macroeconomic environment triggers an economic recession.
An economy is a system that a society uses to produce and exchange goods and services.
The price mechanism is a system for determining the price of goods or services based on the forces of supply and demand.
Scarcity is an economic condition that occurs when the demand for a good or service exceeds the available supply, which limits the choices available to consumers.