Microeconomics Definition

What is Microeconomics

Microeconomics is a study within economics that looks specifically at the behavior of individuals and firms. When considering limited resources, microeconomics looks at how individuals and firms overcome such restrictions and how this influences economic decisions.

For instance, microeconomics covers topics such as the elasticity of demand, fixed and variable costs, externalities, market failure, utility theory, and supply and demand. These specifically look at how businesses and consumers react, so we can predict their behavior in future scenarios.

Microeconomics contrasts with macroeconomics in the fact that it looks at the actions and behavior of individuals and firms. In comparison, macroeconomics looks at the economy as a whole, rather than specific human behavior. It covers areas such as GDP, inflation, and unemployment – factors that affect the economy as a whole.

CHAPTER 1: Supply and Demand

In microeconomics, we focus on how individuals and businesses react when faced with economic constraints. Supply and demand is a key concept within microeconomics and forms a basic understanding by which other variables are considered.

Supply and demand is at the heart of most economic concepts. It stipulates that as demand increases, prices rise in order to attract suppliers to the market and incentivize existing suppliers to increase supply. By doing so, the market reaches what is known as ‘equilibrium’ – where supply and demand meet, thereby resulting in allocative efficiency.

We also have falling demand, which leads to a decline in prices as suppliers look to sell excess supply. In addition to reducing prices, they will also look to reduce capacity, which can have a negative impact on jobs. With prices and demand falling, some firms may go out of business.

Elasticity

Leading on from supply and demand, some products are known to have ‘elastic’ or ‘inelastic’ demand. In the first instance, elastic demand refers to goods that are highly responsive to changes in price. In other words, a small price increase or decrease and cause significant changes in demand. Examples include chocolate, crisps, or other food items. A $0.10 increase in the chocolate bar may encourage consumers to move to another wide variety of options.

By contrast, we have ‘inelastic’ demand, which is where goods are not very responsive to changes in price. Although the price may increase by 10 percent, demand may only fall by 0.1 percent. So people want the product so much that they will pay almost anything to have it. Examples include goods such as Gucci, Ferrari’s, and petrol.

CHAPTER 2: Scarcity and Opportunity Cost

Economics is the study of scarce resources which have alternative uses. So it goes without saying that scarcity is an important aspect of economics. This is because scarcity means resources are limited. Through the study of economics, economists study how these limited resources are best deployed throughout the economy.

Each resource is scarce to some degree and it is this scarcity which helps to determine its value. This is also coupled with other economic jargon such as ‘utility’ which alongside scarcity, determines a goods price. For instance, diamonds are expensive because they are both scarce and grant people with high values of utility. Yet water, which is needed to survive is, valued so low.

The reason being is that most of us have readily available access to water. Our ‘utility’ diminishes from each glass we have, so each additional glass of water is valued lower than the previous. Yet put in a dessert, few individuals would value diamonds over water – because the utility they receive from such is so much higher. At the same time, water as a resource is scarce – so has greater value.

When resources are scarce, they present an opportunity cost whereby we have to decide on purchasing one resource over another. For instance, we may have $5 in our pocket and choose to go and buy a coffee before work. However, the opportunity cost of doing that means we do not have enough money to purchase a bagel or croissant. In other words, we forfeit the opportunity to purchase or do something else, which is known as the opportunity cost.

CHAPTER 3: Market Efficiency

Consumer Surplus

The consumer surplus is the difference between what the consumer is willing to pay and what they actually pay. For example, Mr. Greg may be willing to pay up to $2 for a doughnut, but actually only pays $1.50. The consumer surplus is the difference between $2 (the price he was willing to pay) and $1.50 (the price paid). So in this instance, the consumer surplus is $0.50.

It measures the benefit over and above the price they paid for the good. This is important because this keeps consumers coming back to buy the product again. As there is a consumer surplus, consumers are willing to pay more than they actually are. So as long as there is a consumer surplus, the consumer will feel like they are getting a good deal.

Producer Surplus

In a similar fashion to the consumer surplus, the producer surplus is the difference between what the producer is willing to sell for and what they actually sell for. Usually, this minimum point is at the average cost of production. Any price lower than this would mean a loss to the firm.

For example, Bobs Bicycles produces bicycles at a cost of $500 a unit. The firm would be willing to sell them for at least this price. Anything under this would represent a loss to the firm. So if it sells a bike at $600, then the producer surplus is the difference between that price and the price they would be willing to sell at. In this case, it would be $100.

Allocative Efficiency

Allocative efficiency is where consumer demand is completely met with supply. Both the optimal level of production and demand are met. For example, a bakery may produce 10 loaves of bread. All of which of demanded and sold. So the baker has made exactly the amount that the market has demanded.

This is allocatively efficient because had the baker produced 11 loaves, but only sold 10 – then there would be a wasted loaf. Instead, supply and demand are perfectly met in what is known as allocative efficiency.

Deadweight Loss

Deadweight loss is where there is a loss in economic efficiency that results from a disequilibrium in supply and demand. In other words, there is either an oversupply or an over-demand in the market. For example, if firms are producing more goods than demand for them – those good may go to waste, which is the deadweight loss. As is the case where a bakery produces too many loaves of bread.

CHAPTER 4: Theory of Consumer Demand

Utility

In economics, utility is essentially the benefit or enjoyment that we receive from consuming a good. For example, when we go out for a meal, we gain what is known in economics as ‘utility’. That is the enjoyment or satisfaction that we receive.

Utility is an important part of microeconomics as it is assumed that consumers will always choose to maximize their utility. For instance, the average basketball fan is unlikely to forego a game over the ballet. Consumers will naturally decide on a choice by which maximizes their utility – otherwise, they would not choose it. In turn, this helps us try and establish norms for human behavior as it is assumed that consumers will seek out decisions which maximizes their own utility.

Marginal Utility

Marginal utility refers to the utility we receive when we consume an additional good. For instance, we may enjoy one doughnut, but how much utility would we receive from consuming another? This is an important concept in microeconomics as it allows us to understand human behavior.

Marginal utility has helped us understand why we assign different values to goods that are seemingly worth more than others. For instance, why are diamonds worth more to us than water. Also known as the water-diamond paradox, it helps us explain that once we have had a certain amount of water, our marginal utility for this diminishes. After this point, we assign very little value to it. Yet if we are stuck in a dessert, we value it much more highly.

Diminishing Marginal Utility

The water-diamond paradox leads us onto the topic of diminishing marginal utility. This refers to the declining enjoyment or satisfaction we receive from each additional unit we consume. For instance, we may enjoy the first hotdog more than the second and certainly more than the hundredth (in one sitting of course).

The more we consume of a good, the less value we attach to it – which is why many firms produce offers such as buy 2 get one free. Consumers are unwilling to purchase another good at the same price because the utility they receive from another diminishes. So businesses look to reduce the price of a second unit in a bid to overcome diminishing marginal utility.

CHAPTER 5: Production and Costs

In microeconomics, the cost of production looks at how fixed, variable, and marginal costs impact on how businesses bring goods to market, and the factors that affect the goods final price. In addition, it looks at the competitive environment. For instance, industries with high fixed costs are more likely to result in an oligopoly market structure. This is because when there are fewer competitors, they are able to exploit economies of scale and thereby reduce the cost per unit.

Fixed Cost

A fixed cost is the amount a business must pay whether it produces one good or two million goods. It is a cost that does not change – even at higher levels of output. For instance, a business may have to pay rent on the unit it occupies. The rent is payable at a set fee each year – a fixed cost. So whether the business sells nothing or it sells 10 million goods – it still has to pay that cost.

Variable Cost

A variable cost differs from a fixed cost in the fact that it varies depending on how many goods are produced. In other words, variable costs increase alongside output. For instance, it may cost McDonalds $2 to produce Big Mac. To produce two Big Macs, it may cost $3.50, so its total variable cost is $3.50. This is because the cost of goods such as hamburgers, lettuce, buns, and tomatoes, are all variable. The more McDonalds produces, the more it will cost them in variable elements.

Marginal Cost

The marginal cost is the additional cost it takes to produce one extra good. For instance, it may cost PlayStation $200 to make the PlayStation 5. The cost to make another is $150 – and is therefore the marginal cost. It is similar to variable costs in the fact that the cost to make another good is generally variable. However, once a company reaches capacity, it may need to invest in another store, thereby creating a new fixed cost. So to produce another good at that point, it would include both fixed and variable costs.

Economies of Scale

In microeconomics, economies of scale refers to the efficiencies a firm gains as it increases in size. As the firm grows bigger, it is able to benefit from reduced costs such as being able to buy in bulk and obtain cheap credit. At the same time, it benefits from reduced costs per customer. For instance, a manufacturer that is able to keep production running 24/7 is able to efficiently utilise its floor space and capital equipment more so than one which only operates five hours a day.

CHAPTER 6: Market Structure

Market structures are an important aspect of microeconomics. It helps us identify different markets and how and why they exist. For instance, perfect competition is the epitome of economic allocation. There are many competitors in the market, pushing down prices for consumers, which creates a competitive environment that benefits consumers. Yet it is a hypothetical structure which exists merely as a reference point.

These market structures identify the drawbacks of each and highlight why a competitive environment is the best outcome for the consumer. If we take monopolies for example – a single company that can dictate supply and prices is bad for the consumer. They can end up paying over and above the cost of production. At the same time, the monopoly itself may suffer.

Without competition, firms have little incentive to innovate or improve efficiency. By having competition, firms have to create new products, reduce prices, and increase efficiencies. Yet without that, we have bloated firms that are inefficient and care little about the consumer.

As a result of microeconomics and the development of market structures, institutions that monitor competition have developed. This includes the Federal Trade Commission in the US and the Competition Commission in Europe. The aim – to ensure there is a competitive environment that benefits the consumer.

Oligopoly

An oligopoly is where a few firms have a dominant position in the market. In fact, many markets today come in the form of an oligopoly. For instance, firms such as Apple, Samsung, and Huawei, dominate the smart phone market. We also have the telecoms market which is dominated in the US by Sprint, Verizon, T-Mobil, and AT&T. Combined, they own around 98 percent of the US market.

Oligopoly’s are often seen as a bad thing. With only a few firms in the market, there isn’t that same competitive environment that spurs innovation and efficiency. Firms will find it difficult to take business away from each other, so instead seek to maintain their market position – which may also lead to collusion.

Monopoly

A monopoly is where one firm completely dominates the market. In other words, there is no other seller of that good. For example, Microsoft could class as having a monopoly in the early 2000s, but has since lost market share to Apple. We also have the De Beers diamond conglomerate which had a monopoly in the diamond market for much of the 20th century.

These monopolies have similar characteristics to an oligopoly in the fact that there is little competition. A monopoly itself has no direct competitors, although may face competition from substitute goods. In turn, the lack of competition can lead some monopolies to inefficiency and high prices for consumers. After all, what is the need when consumers are forced to buy from the firm anyway?

Perfect Competition

Perfect competition refers to a market where there are many sellers and many buyers – all with equal market share. It is both easy to enter and leave the market, whilst buyers have full information on what they are buying. This type of market structure is one that most economists strive to achieve as it is the best outcome for consumers.

There is a wide variety of choice and prices are virtually the same as the cost of production. The competitive nature forces rock bottom prices else the one that rises them will go out of business as there are hundreds of other firms to choose from.

Monopolistic

Monopolistic is a type of imperfect competition which is characterized by many firms in the market, but each with a slightly different product offering. Each firm competes on product differentiation, whilst the market is imperfect because consumers have little information on each product.

Monopsony

Not to be confused with a monopoly – a monopsony is where the buyer in the supply chain is the only firm in the market. At the same time, there are many sellers of the good. So they all compete fiercely in order to get the custom of the buyer.

In the same way a monopoly has the ability to set prices, so too do monopsony firms over their suppliers. For instance, a local manufacturing firm may be able to dictate wages to its employees (suppliers of labor) as there are no other jobs in the area.

CHAPTER 7: Market Failure

Externalities

In microeconomics, externalities refer to the external effects that consumption and production have on third parties. These can be negative externalities in the form of pollution, or, positive externalities in terms of public goods such as parks and libraries.

The most common examples of externalities include where factories pollute the local water supply. This then impacts on the downstream users of the rivers or lakes. Perhaps they are fishers or just use the water for drinking. Therefore, the initial pollution from the factories has an impact on these downstream users.

Market Failure

In markets that produce externalities, they are known to have market failure. This is because the social price of the good is not incorporated into the private cost. In other words, the consumer is not paying for the external damage, or, in the case of positive externalities, the third parties are not paying for the benefit.

If we look at pollution for example. Firms release carbon dioxide into the atmosphere or perhaps pollution the local water supply. This presents a cost onto third parties who are not compensated for such.

At the same time, market failure can also occur when firms over and undersupply the market. When the market is undersupplied, consumers are left without the goods they want. And when the market is oversupplied, the firm is left with goods that nobody wants – leading to deadweight loss and economic waste. Therefore, the market has failed to allocate resources effectively

Public Goods

When markets fail, governments often intervene in order to correct such. Looking at the education system for example – most governments across the world offer this in order to resolve what is seen as a market failure in the education system. This is because the social benefits of universal education are seen to far outweigh the costs. If left up to the market, not all children would receive an education, thereby exasperating social division. Instead, by providing an education for all, those from low-income backgrounds are able to have access and work their way up the social ladder.

CHAPTER 8: Information, Risk, and Insurance

Asymmetric Information

In microeconomics, asymmetric information refers to where one party has more information about the good than the other. For example, a second-hand car salesman may know that the car has a few faults, but the buyer is unaware of these. In turn, the buyer’s valuation is higher that the goods true value had they been aware of those faults. This can lead to economic loss due to the fact the consumer is paying over and above the goods true market value. However, this is due to asymmetric information.

Principal Agent Problem

The principal agent problem relates to the microeconomic issue between the ‘principal’ (the customer) and the ‘agent’ (the supplier). It refers to the disparities in individual interests between the agent and the principal – which can lead to unfavourable actions being taken by the agent on behalf of the principal. For example, the interests of executives and shareholders are not always aligned. Whilst many shareholders are interested in long-term market capitalisation, executives have an interest to hit short-term targets in order to obtain certain bonuses. This is why many firms such as Apple require executives to own shares in the firm – so as to align the interests of both parties.

Moral Hazard

In microeconomics, a moral hazard occurs when an individual becomes increasingly reckless as they know the monetary effects will be borne by a third party. This is a common economic issue with relation to insurance whereby the customer takes greater risks once they are covered. For example, they may leave their laptop unattended at the library, or park in an inappropriate location. This is because they know there is little cost associated with their poor risk management.

FAQs on Microeconomics

About Paul

Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.

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