(from prefix "micr(o)-" meaning
"small" + "economics") is a branch of economics
that studies how households and firms
make decisions to allocate limited resources, typically in markets
where goods or services are being bought and sold. Microeconomics
examines how these decisions and behaviours affect the supply and demand
for goods and services,
which determines prices; and how prices, in turn, determine the
supply and demand of goods and services.
This is a contrast to macroeconomics
which involves the "sum total of economic activity, dealing with
the issues of growth
, and with national economic
policies relating to these issues". Macroeconomics also deals with
the effects of government actions (such as changing taxation
levels) on them. Particularly in the wake
of the Lucas critique
, much of modern
macroeconomic theory has been built upon 'microfoundations
' — i.e. based upon basic
assumptions about micro-level behaviour.
One of the goals of microeconomics is to analyze market
mechanisms that establish relative price
amongst goods and services and
allocation of limited resources amongst many alternative uses.
Microeconomics analyzes market
, where markets fail to produce efficient results, as
well as describing the theoretical conditions needed for perfect competition
. Significant fields
of study in microeconomics include general equilibrium
, markets under
choice under uncertainty
applications of game theory
considered is the elasticity
of products within the market system.
Assumptions and definitions
The theory of supply and demand
usually assumes that markets are perfectly competitive
. This implies that
there are many buyers and sellers in the market and none of them
has the capacity to significantly influence prices of goods and
services. In many real-life transactions, the assumption fails
because some individual buyers or sellers have the ability to
influence prices. Quite often a sophisticated analysis is required
to understand the demand-supply equation of a good model. However,
the theory works well in simple situations.
that markets are preferable to other forms of
social organization. In fact, much analysis is devoted to cases
where so-called market failures
to resource allocation
suboptimal by some standard (highways are the classic example,
profitable to all for use but not directly profitable for anyone to
finance). In such cases, economists may attempt to find policies
that will avoid waste directly by government control, indirectly by
regulation that induces market participants to act in a manner
consistent with optimal welfare, or by creating "missing markets
" to enable efficient trading
where none had previously existed. This is studied in the field of
. It also must be
noted that "optimal welfare" usually takes on a Paretian
norm, which in its mathematical
application of Kaldor-Hicks
, does not stay consistent with the Utilitarian norm
within the normative side of economics which studies collective
action, namely public choice. Market failure in positive economics
(microeconomics) is limited in implications without mixing the
belief of the economist and his or her theory.
The demand for various commodities by individuals is generally
thought of as the outcome of a utility-maximizing process. The
interpretation of this relationship between price and quantity
demanded of a given good is that, given all the other goods and
constraints, this set of choices is that one which makes the
Modes of operation
It is assumed that all firms are following rational
decision-making, and will produce at the profit-maximizing output.
Given this assumption, there are four categories in which a firm's
profit may be considered.
- A firm is said to be making an economic profit when its average total cost
is less than the price of each additional product at the
profit-maximizing output. The economic profit is equal to the
quantity output multiplied by the difference between the average
total cost and the price.
- A firm is said to be making a normal
profit when its economic profit equals zero. This occurs where
average total cost equals price at the profit-maximizing
- If the price is between average total cost and average variable
cost at the profit-maximizing output, then the firm is said to be
in a loss-minimizing condition. The firm should still continue to
produce, however, since its loss would be larger if it were to stop
producing. By continuing production, the firm can offset its
variable cost and at least part of its fixed cost, but by stopping
completely it would lose the entirety of its fixed cost.
- If the price is below average variable cost at the
profit-maximizing output, the firm should go into shutdown. Losses are minimized by not
producing at all, since any production would not generate returns
significant enough to offset any fixed cost and part of the
variable cost. By not producing, the
firm loses only its fixed cost. By losing this fixed cost the
company faces a challenge. It must either exit the market or remain
in the market and risk a complete loss.
In microeconomics, the term "market failure" does not
that a given market has ceased functioning. Instead, a market
failure is a situation in which a given market
does not efficiently organize production or
allocate goods and services to consumers. Economists normally apply
the term to situations where the assumptions of the First Welfare Theorem
fail leading to
the market outcome no longer being on the Pareto frontier
. On the other hand, in a
political context, stakeholders
the term market failure
to refer to situations where
market forces do not serve the public
The four main types or causes of market failure are:
- Monopolies or other cases of abuse of
market power where a "single buyer or seller can exert significant
influence over prices or output". Abuse of market power can be
reduced by using antitrust
- Externalities, which occur in
cases where the "market does not take into account the impact of an
economic activity on outsiders." There are positive externalities
and negative externalities. Positive externalities occur in cases
such as when a television program on family health improves the
public's health. Negative externalities occur in cases such as when
a company’s processes pollutes air or waterways. Negative
externalities can be reduced by using government regulations,
taxes, or subsidies, or by using property rights to force companies
and individuals to take the impacts of their economic activity into
- Public goods are goods that have the
characteristics that they are non-excludable and non-rivalrous and
include national defense, public transportation, federal
highways, and public health
initiatives such as draining mosquito-breeding marshes. For
example, if draining mosquito-breeding marshes was left to the
private market, far fewer marshes would probably be drained. To
provide a good supply of public goods, nations typically use taxes
that compel all residents to pay for these public goods (due to
scarce knowledge of the positive externalities to third
parties/social welfare); and
- Cases where there is asymmetric information or uncertainty
(information inefficiency). Information asymmetry occurs when one
party to a transaction has more or better information than the
other party. For example, used-car salespeople may know whether a
used car has been used as a delivery vehicle or taxi, information
that may not be available to buyers. Typically it is the seller
that knows more about the product than the buyer, but this is not
always the case. An example of a situation where the buyer may have
better information than the seller would be an estate sale of a
house, as required by a last will and testament. A real estate
broker buying this house may have more knowledge about the house
than the family members of the deceased.
- This situation was first described by Kenneth J. Arrow in a seminal article on health care
in 1963 entitled "Uncertainty and the Welfare Economics of Medical
Care," in the American Economic Review. George Akerlof later used the term asymmetric
information in his 1970 work The Market for Lemons. Akerlof
noticed that, in such a market, the average value of the commodity tends to go down, even for those of
perfectly good quality, because the buyer has no way of knowing
whether the product they are buying will turn out to be a "lemon"
(a defective product).
Although opportunity cost
can be hard to quantify, the
effect of opportunity cost is universal and very real on the
individual level. In fact, this principle applies to all decisions,
not just economic ones.Since the work of the Austrian
economist Friedrich von Wieser
, opportunity cost
has been seen as the foundation of the marginal theory of value
Opportunity cost is one way to measure the cost of something.
Rather than merely identifying and adding the costs of a project,
one may also identify the next best alternative way to spend the
same amount of money. The forgone profit of this next best
is the opportunity cost of the original choice. A
common example is a farmer that chooses to farm her or his land
rather than rent it to neighbors, wherein the opportunity cost is
the forgone profit from renting. In this case, the farmer may
expect to generate more profit alone. Similarly, the opportunity
cost of attending university
is the lost
wages a student could have earned in the workforce, rather than the
cost of tuition, books, and other requisite items (whose sum makes
up the total cost of attendance). The opportunity cost of a vacation in the
Bahamas might be the down payment money for a house.
Note that opportunity cost is not the sum
of the available
alternatives, but rather the benefit of the single, best
alternative. Possible opportunity costs of the city's decision to
build the hospital on its vacant land are the loss of the land for
a sporting center, or
the inability to use the land for a
parking lot, or
the money that could have been made from
selling the land, or
the loss of any of the various other
possible uses—but not all of these in aggregate. The true
opportunity cost would be the forgone profit of the most lucrative
of those listed.
One question that arises here is how to assess the benefit of disse
must determine a dollar value associated with each alternative to
facilitate comparison and assess opportunity cost, which may be
more or less difficult depending on the things we are trying to
compare. For example, many decisions involve environmental impacts
whose dollar value is difficult to assess because of scientific
uncertainty. Valuing a human life or the economic impact of an
Arctic oil spill involves making subjective choices with ethical
It is imperative to understand that nothing is free. No matter what
one chooses to do, he or she is always giving something up in
return. The quote, "There is no such thing as a free lunch" relates
to this because by eating that "lunch", one is giving up the chance
to be doing something else. Another example of opportunity cost is
deciding between going to a concert and doing homework. If one
decides to go the concert, then he or she is giving up valuable
time to study, but if he or she chooses to do homework then the
cost is giving up the concert. Opportunity Cost is vital in
understanding microeconomics and decisions that are made.
Applied microeconomics includes a range of specialized areas of
study, many of which draw on methods from other fields. Applied
work often uses little more than the basics of price
, supply and
organization and regulation
examines topics such as
the entry and exit of firms, innovation, role of trademarks.
Law and economics
applies microeconomic principles to the selection and enforcement
of competing legal regimes and their relative efficiencies.
examines wages, employment, and
labor market dynamics. Public finance
public economics) examines the design of government tax and
expenditure policies and economic effects of these policies (e.g.,
social insurance programs). Political economy
examines the role of political institutions in determining policy
outcomes. Health economics
organization of health care systems, including the role of the
health care workforce and health insurance programs. Urban
, which examines the challenges faced by cities,
such as sprawl, air and water pollution, traffic congestion, and
poverty, draws on the fields of urban geography and sociology. The
field of financial economics
examines topics such
as the structure of optimal portfolios, the rate of return to
capital, econometric analysis of security returns, and corporate
financial behavior. The field of economic history
examines the evolution of the economy and economic institutions,
using methods and techniques from the fields of economics, history,
geography, sociology, psychology, and political science.
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