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Microeconomics

Have you ever wondered where the ‘micro’ in microeconomics comes from? Do you know the difference between macroeconomics and microeconomics? You’re probably thinking: macro - big, micro - small, and you are not wrong. If you’ve heard about microeconomics before, but are not sure where to start, you have come to the right place. This explanation will not only explain the meaning of microeconomics but will also introduce the seven main blocks that make up the foundations of microeconomics theory.

What is microeconomics?

Microeconomics is the branch of economics that studies the behaviour of individuals, households, and firms regarding their decision-making in the allocation of their scarce resources. It also studies the interaction between these agents.

In other words, microeconomics attempts to understand the decision-making process of individual actors such as buyers, sellers, and business owners while studying how they respond to changes in incentives, prices, resources, and/or methods of production.

What will happen with the demand for office space in the future as more people are working from home and are demanding online platforms such as Zoom or Google Meet? This is a question that economists today could study.

Microeconomics Work from home setting StudySmarterTypical work from home setting. Source: Chris Montgomery, Unsplash.

Microeconomics vs. macroeconomics

The study of economics is divided into two branches: microeconomics and macroeconomics. The main difference between microeconomics and macroeconomics is their scope. Microeconomics is a study on a smaller scale as it focuses on parts of the economy such as individuals, firms, and industries. Macroeconomics has a broader focus and looks at the economy as a whole.

Suppose we study the decision-making of a particular car manufacturing company such as Bentley. In that case, we will have to use microeconomic principles, but if we study the entire car manufacturing sector of the economy, we will have to conduct a macroeconomic analysis. If we study the production process of an individual company, we will have to think of it as a microeconomic issue. But if we study the production problems of the whole economy, we will have to approach it as a macroeconomic topic.

Keep in mind that although microeconomics and macroeconomics represent two different perspectives, they are not separate subjects. They complementary perspectives on the overall subject of the economy.

Think of inflation as an example. Although inflation, a decrease in the power of money, is a macroeconomic variable, it also affects the micro-decisions of individuals and firms. Thus, if a company faces increased prices for raw materials and inflated wages, it will also have to increase the prices of the goods and services it offers to cover its expenses and generate profit. Furthermore, household individuals (following the law of demand) might consume less of the goods or services, as their price is now higher.

The structure of microeconomic theory

Microeconomic theory studies how individual units of the economy make decisions with scarce resources while facing changes. As you already know from your own experience, due to your limited time and income you can’t do or buy everything you might want to, but you have to make choices between alternatives on a regular basis.

Have you had to decide between going to the cinema with your friend or staying home and studying? Or between buying a suit for your job interview or saving the money for a new iPhone? Have you wondered if you should still buy beef even though it’s way more expensive than chicken?

To give you a better understanding of each individual’s decision-making process, StudySmarter has divided the study of microeconomics into seven blocks:

1. Consumer rationality

2. Price determination in a competitive market

3. Production, cost, and revenues

4. Market structures

5. Labour market

6. Market failure

7. Distribution of wealth

Consumer rationality

The theory of consumer behaviour tries to explain how consumers make choices on how to spend their money based on their individual preferences and budget constraints.

Since economics is a social science, every model or theory makes some assumptions, which are weaknesses or limitations to those models.

Some important assumptions that shape the theory of consumer behaviour are:

  • Consumers make rational choices based on their preferences. They always choose the feasible alternative that they would prefer the most.

  • By being rational, consumers will strive to maximise their utility. This is the total satisfaction a consumer receives while consuming their chosen good or service.

  • Consumer preferences are insatiable, which means that they will always look for more of a good, more of a service, and more utility. They will almost always benefit from additional consumption.

  • However, due to the law of diminishing marginal utility, as consumption increases, each additional unit’s marginal utility declines.

Marginal utility is the additional satisfaction (utility) a consumer gets, after getting an additional unit of a good or service.

If you like ice cream and you eat a scoop, you will feel satisfied. One or two extra ice cream scoops will further increase your satisfaction (utility). But after having eaten three, any additional ice cream scoop won’t have a meaningful increase on your utility.

Price determination in a competitive market

Price theory in microeconomics is concerned with the study of the price determination process for goods and services in the marketplace.

Generally speaking, the term ‘price’ is the monetary value of a good or service. But in microeconomics, price is a function of demand and supply.

Demand is the amount of goods or services consumers are willing and able to purchase at each price level.

Supply is the amount of goods or services that producers are willing and able to offer at each price level.

In this block, you will focus on how the price is determined in a perfectly competitive market.

A perfectly competitive market is another assumption. It is an ideal market where many firms operate but none of them has a dominant position to determine or influence the price of a good or service. Thus, all firms in a perfectly competitive market take the price set by the market.

The interaction of the two market forces (supply and demand) determines the price in a competitive market. When the supplied quantity of a good or service equals the demanded quantity of that good or service, we say that the market has reached equilibrium. The price at which this intersection occurs is the equilibrium price.

The equilibrium price is the price at which the supplied quantity for a good or service equals the demanded quantity for that good or service.

Figure 1 below shows the equilibrium price where supply is equal to demand:

microeconomics price equilibrium studysmarterFigure 1. Price equilibrium - StudySmarter Originals

Production, costs, and revenues

Production, costs, and revenues are the key concepts of the theory of production. To understand these concepts, you should have a general understanding of production theory.

The theory of production examines the relationship between the production factors used during the process and the output produced.

Economists define production factors as resources needed to produce goods and services. They divide them into four categories:

  • Land

  • Labour

  • Capital

  • Entrepreneurship

The price and number of factors used in a good or service’s production process give us the costs that a firm incurs. The price and quantity of goods or services produced and sold represent the revenues that a firm generates.

You will learn more about costs, revenues, their different types, and how to calculate them in the articles dedicated specifically to each.

Microeconomics The four factors of production figure StudySmarterFigure 2. The four factors of production, StudySmarter Originals.

Market structures

Market structures refer to the nature and degree of competition in the market for goods and services.

The four most prevalent market structures are:

  • Perfect competition

  • Monopolistic competition

  • Oligopoly

  • Monopoly

We classify and differentiate these market structures based on the following characteristics:

  • The number of producers Many, few, or a single producer in the market indicate what market structure you are dealing with. For example, if you hear or read ‘a single producer in the market,’ it should be clear to you that it refers to a monopoly.

  • The degree of product differentiation Product characteristics such as unique, homogeneous, or slightly differentiated are inseparable from the market structure. For example, homogeneous products are indistinguishable products and are a key characteristic of perfect competition.

  • The pricing power of the producer The degrees of pricing power vary between full, little, or no pricing power. We can also classify firms as price-takers or price-makers. In a monopoly, the firm is considered a price maker, as the producer in a monopoly market has full pricing power.

  • The barriers to entry into the market Entry barriers refer to the fixed costs a new producer has to pay prior to entering a market. The presence or near absence of barriers to entry helps to classify the market structures. For example, in perfect competition, there aren’t any entry barriers.

  • The level of non-price competition A low, moderate, or high level of non-price competition is an indicator of a specific market structure. For instance, if non-price competition is present, it indicates any other market structure apart from perfect competition.

Figure 3 below shows the four market structures as a spectrum from perfect competition to monopoly:

Microeconomics Spectrum of market structures StudySmarterFigure 3. The spectrum of market structures, StudySmarter Originals.

Labour market

Keep in mind that the labour market is under the focus of both microeconomic and macroeconomic perspectives. Here, we will provide a brief description of how to analyse it on a micro-level.

The labour market is where workers and employers interact. In the labour market, workers provide the supply of labour and employers generate demand for labour. In theory, workers will compete for the jobs which provide the most incentives, while employers will compete for the most skilled workers.

Think of demand for labour in terms of an individual firm and of supply for labour in terms of that firm’s workers.

The labour market is a vital component of any and every economy. Without it, we wouldn’t be able to make or sell goods and services.

In economics, households supply their labour to firms for an income, and firms demand that labour from households. Households then use the wages earned by their supply of labour to demand goods and services from firms. Wages are the price firms are willing to pay for workers’ labour.

Keep in mind that in a true free-market economy, wages would be determined by demand and supply forces. In the real world, however, there are more interactions at play, and the government, as well as trade unions, can influence wage levels.

The interaction between the employees and the employer happens in the form of bargaining over wages. Employees form trade unions, which bargain for higher wages on their behalf, by directly affecting the labour supply.

The demand for labour is mainly determined by:

  • A firm’s marginal cost of production, which is the increase in a firm’s total production cost from hiring an additional worker.

  • The marginal revenue product of labour, which is the extra revenue generated when an additional worker is hired.

As for the supply of labour, it is mainly determined by:

  • The substitution effect, which assumes that higher wages lead to workers substituting leisure to work.

  • The income effect, which assumes that higher wages lead to workers supplying less labour.


Market failure

Market failure occurs when the price mechanism fails to allocate resources efficiently, or when the price mechanism fails to function altogether.

Let’s analyse the UK’s healthcare market. As healthcare in the UK is free at the point of use, it has a high level of demand. Consequently, because the demand is too high, it becomes increasingly difficult to meet it. Patients continuously deal with long waiting times.

If there was more investment in healthcare technology, which would allow treating patients’ cases faster, this demand would be met.

Therefore, we can say that in this case, there is an under-provision of healthcare technology relative to what is socially optimal. This is a case of market failure.

Figure 4 below illustrates a case of market failure:

microeconomics market failure studysmarterFigure 4. Market failure, StudySmarter Originals.

Various factors can potentially cause market failure:

  • Externalities. These are indirect costs in case of a negative externality or indirect benefits in case of a positive externality. These are consequences a third party has by consuming or producing a good or service. For example, air pollution is a negative externality of certain firms, and public education is a positive externality that has indirect benefits to society.

  • Public goods. These are commodities or services available for all consumers of society. They have a fixed cost of production, no matter the number of consumers of that good. For example, street lighting.

  • Merit goods. These are commodities or services provided for free or relatively cheaply to encourage their consumption. For example, public education.

  • Demerit goods. These are commodities or services that are considered to have a negative effect on consumers. For example, smoking.

The government often intervenes in the markets in order to correct market failures.

Distribution of income and wealth

The problems of unequal distribution of income and wealth, and poverty are more on focus nowadays.

These issues encompass a variety of topics in economics including:

  • The current situation of the distribution of household income and wealth in the United Kingdom and in the world.

  • The difficulty of measuring inequality.

  • The policies that governments use to influence the distribution of income and wealth and to alleviate poverty.

Wealth is the stock or monetary value of a person’s marketable assets. For the majority of the population, wealth is measured at a particular moment in time. For example, the current house and accumulated savings, pensions, life insurance policies, and other current assets such as jewelry or vehicles.

Income inequality is the degree to which income is distributed unequally throughout a population.

Economists measure income inequality using a variety of criteria. One of the most generally used measures is the Gini coefficient. The value of the Gini coefficient ranges from 0 to 1. A coefficient of 0 indicates perfect equality. It means that every 1% of a population has access to 1% of the national income, which is unrealistic. A coefficient of 1 indicates perfect inequality. It means that 1 individual has access to 100% of the country’s national income.

Figure 5 below shows the possible values of the Gini coefficient:

Microeconomics Gini coefficient scale StudySmarterFigure 5. Gini coefficient scale, StudySmarter Originals.

The Gini coefficient is important because it helps economists measure income or wealth inequality. Economists are interested in how income and wealth inequality change over time in an economy as well as the difference in economic inequality between different countries.

The Gini coefficient is a good relative measure of income inequality. However, it does not tell us anything about the absolute numbers. This is why microeconomics also studies the problem of poverty.

Poverty occurs when a person can’t afford basic human needs such as food, clothing, shelter, safe drinking water, health care, sanitation, and minimal educational opportunities.

The problems of unequal distribution of income and wealth, and poverty persist despite the overall improvements in the standard of living across the globe. This is happening due to the gap between the world’s richest and poorest widening every year.

Microeconomics is a fantastic subject that will help you understand and explain many of the existing world’s problems: from consumer choice to income inequality. And maybe, one day, you will be a leader who will shape the future of the world for the better!

Microeconomics - Key takeaways

  • Microeconomics is the branch of economics that studies the behaviour of individuals, households, and firms regarding the allocation of their scarce resources in decision-making. It also studies the interaction between these agents.
  • Microeconomic theory is about how individual units of the economy make decisions with scarce resources while facing changes.
  • The theory of consumer behaviour tries to explain how consumers make choices on how to spend their money based on their individual preferences and budget constraints.
  • The theory of production examines the relationship between the factors of production used during the process and the output produced.
  • Market structures refer to the nature and degree of competition in the market for goods and services.
  • The labour market is where workers and employers interact. In the labour market, workers provide the supply of labour and employers generate demand for labour.
  • Market failure occurs when the price mechanism fails to allocate resources efficiently, or when the price mechanism fails to function altogether.
  • The problems of unequal distribution of income and wealth, and poverty persist despite the overall improvements in the standard of living across the globe.

Frequently Asked Questions about Microeconomics

Microeconomics is the branch of economics that studies the decision-making of individuals, households, and firms regarding the allocation of their scarce resources, and the interaction between these agents.

The main difference between microeconomics and macroeconomics is their scope. Microeconomics is a study on a smaller scale, as it focuses on parts of the economy such as individuals, firms, and industries. Macroeconomics has a broader focus and looks at the economy as a whole.

The fields of study in microeconomics are many and varied but the main are:

1. Consumer rationality

2. Price determination in a competitive market

3. Production, cost, and revenues 

4. Market structures 

5. Labour market 

6. Market failure 

7. Distribution of wealth

Some theories of microeconomics include, but are not limited to:

1. Consumer choice theory

2. Production theory

3. Labour market theory

The microeconomic theory objectives are to explain how individual units of the economy make decisions with scarce resources while facing changes.

Final Microeconomics Quiz

Question

What is microeconomics?

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Answer

Microeconomics is the branch of economics that studies the decision-making of individuals, households, and firms regarding the allocation of their scarce resources. It also studies the interaction between these agents.

Show question

Question

What is the difference between microeconomics and macroeconomics?

Show answer

Answer

The main difference between microeconomics and macroeconomics is their scope. Microeconomics is a study on a smaller scale, as it focuses on parts of the economy such as individuals, firms, and industries. Macroeconomics has a broader focus and looks at the economy as a whole.

Show question

Question

Name three fields of study in microeconomics.


Show answer

Answer

Any three from:

1. Consumer rationality

2. Price determination in a competitive market

3. Production, costs, and Revenues 

4. Market structures 

5. Labour market 

6. Market failure 

7. Distribution of wealth

Show question

Question

What are some of the theories of microeconomics?


Show answer

Answer

Some theories of microeconomics are:

1. Consumer choice theory

2. Production theory

3. Labour market theory

Show question

Question

What does the theory of consumer behaviour study?

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Answer

The theory of consumer behaviour tries to explain how consumers make choices on how to spend their money based on their individual preferences and budget constraints.

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Question

What does the theory of production study?


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Answer

The theory of production examines the relationship between the factors of production used during the process and the output produced.

Show question

Question

What are market structures?

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Answer

Market structures refer to the nature and degree of competition in the market for goods and services.

Show question

Question

What is the labour market?


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Answer

The labour market is where workers and employers interact. In the labour market, workers provide the supply of labour and employers generate a demand for labour.

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Question

What is market failure?


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Answer

Market failure occurs when the price mechanism fails to allocate resources efficiently, or when the price mechanism fails to function altogether.

Show question

Question

Why is there a need to study income and wealth inequality today?


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Answer

The problems of unequal distribution of income and wealth, and of poverty persist despite the overall improvements in the standard of living across the globe. This is especially the case due to the gap between the world's richest and poorest widening every year.

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