In This Chapter
Introducing the areas that are the focus of microeconomics
Understanding the key roles of rational decision-making, competition, and cooperation
Seeing that markets donât always work
As weâre sure you know, micro as a prefix often indicates something very small, such as a microchip or a microcosm. Micro can also mean something that isnât small itself but that is used to examine small things, such as a microscope.
Microeconomics is the area of economics that studies the decisions of individual consumers and producers and how they come together to make markets. It explores how people decide to do what they do and what happens when interests conflict. It also considers how people can improve markets through their actions, the effects of laws, and other outside interventions. So despite the name, microeconomics is in fact a huge subject.
Traditionally, people contrasted microeconomics with macroeconomics â the study of national economies and weighty topics such as growth, unemployment, inflation, national debt, and investments. But over the years, the scope of microeconomics has grown; today economists analyze topics in macroeconomics using microeconomic tools.
Microeconomists employ those tools to look at things that form from the bottom up, because markets build on the actions of individual companies and consumers. This approach involves starting with an account of how companies and consumers make decisions and building on that to investigate more complex things that âemergeâ from those decisions â such as how a market is structured.
In general, microeconomics works by building models of these situations. Models are mathematical â or graphical â pictures of how the world works given some basic assumptions. Models arenât reality; theyâre a description of something that resembles reality. Like an architectâs model of a house, models donât have to stand up to reality; they just have to provide a feeling for what the real world looks like. Microeconomists also test models against real data to see how well the models work â the answer is often variably.
This chapter introduces you to microeconomics and its core areas of interest, and we touch on the fact that markets donât always work.
Peering into the Economics of Smaller Units
Microeconomics is fundamentally about what happens when individuals and companies make decisions. The idea is to understand how those decisions are made and explore their consequences.
What happens, for example, when prices of houses go up? Well, on the one hand, people are likely to buy fewer or smaller houses. On the other hand, developers may want to build more houses so that they can get more revenue. The result could be a lot of unsold houses! Then there will be pressure to get rid of those stocks of unsold houses, and that leads to lower prices.
When does that process stop? At the limit, the only logical place to stop cutting the price is when exactly as much is sold as is available to sell. This point is called an
equilibrium in the housing market â a place where supply and demand are equal.
Chapter 9 discusses equilibria more fully.
When people talk about
market forces, theyâre talking about the outcome of all these decisions taken together. No vast impersonal power called âmarket forcesâ exists, just a lot of smaller entities â consumers and companies â making a lot of simple decisions based on signals that come from prices. Thatâs really all market forces means.
The way markets work seems so impersonal because every one of the smallest units â small companies and individuals â makes up just a tiny fraction of all the decisions taken. Even the biggest corporations or most powerful governments have limitations on their ability to influence the world. Microeconomics also looks at the exception to the rule when a decision-maker â a buyer or seller â is not so small and can influence market forces.
All these small decision-makers do the best they can, given that ultimately theyâre acting with imperfect knowledge of a complicated world. People and companies canât know
exactly how much theyâll be earning next year or exactly how much theyâll sell. They just look for ways of making decisions that give them the best chance of doing the best they can â which is about all anyone can ask for in an uncertain world.
Making Decisions, Decisions, and More Decisions!
One word thatâs central to microeconomics is
decision. Microeconomics is ultimately about making decisions: whether to buy a house, how much ice cream to make, what price to sell a bicycle at, or whether to offer a product to this or that market, and so on.
This is one reason why economists center their models on choice. After all, when you donât have options to choose from, you canât make a decision. Deciding to make something or to buy something is the starting point for microeconomics.
To a microeconomist, decisions arenât right or wrong. Instead, theyâre one of the following:
-
Optimal: Getting the best of what you want, given whatâs available.
- Sub-optimal: Getting less than the best.
Of course, a model of decisions needs two sides:
- Consumers base their decisions on the value they get from choosing one option as opposed to another.
- Companies base their decisions on a measure of monetary benefit â revenue against costs.
This book presents a few ways that microeconomists look at these decisions. Chapters 2â8 use a framework for making the best decision given some kind of constraint â budget, time, or whatever else constrains you â to show you how microeconomists look at individuals and companies separately. In Chapters 9â15, the famous supply and demand model shows you how different types of markets lead to different results. And Chapters 16â19 introduce you to game theory, which looks at how individuals or companies (or even other entities, such as governments) strategically interact with each other.
Addressing how individuals and companies make decisions
Economists look at decisions in a slightly different way from how you might expect. They...