Microeconomics and Its Main Functions

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Microeconomics is the study of how individuals and firms make themselves as well off as possible in a world of scarcity, and the consequences of those individual decisions for markets and the entire economy (David A., 2004). In studying microeconomics, we examine how individual consumers and firms make decisions and how the interaction of many individual decisions that affects markets.

Microeconomics is often called price theory to emphasize the important role that prices play in determining market outcomes. Microeconomics explains how the actions of all buyers and sellers determine prices and how prices influence the decisions and actions of individual buyers and sellers.

To explain how individuals and firms allocate resources and how market prices are determined, economists use a model: a description of the relationship between two or more economic variables. Economists also use models to predict how a change in one variable will affect another variable.

Economic theory is the development and use of a model to test hypotheses, which are predictions about cause and effect. We are interested in models that make clear, testable predictions, such as “If the price rises, the quantity demanded falls”. A theory saying that “People’s behaviour depends on their tastes, and their tastes change randomly at random intervals” is not very useful because it does not lead to testable predictions.

Economists test theories by checking whether predictions are correct. If a prediction does not come true, economists may reject the theory. Economists use a model until it is refuted by evidence or until a better model is developed. A good model makes sharp, clear predictions that are consistent with reality. Some very simple models make sharp predictions that are incorrect, and other, more complete models make ambiguous predictions in which any outcome is possible that are untestable.

Microeconomics and Individual Use of Limited Resources

Individuals and firms allocate their limited resources to make themselves as well off as possible. Consumers pick the mix of goods and services that makes them as happy as possible given their limited wealth. Firms decide which goods to produce, where to produce them, how much to produce to maximize their profits, and how to produce those levels of output at the lowest cost by using more or less of various inputs such as labor, capital, materials, and energy. The owners of a depletable natural resource such as oil decide when to use it. Government decision makers decide which goods and services the government will produce and whether to subsidize, tax, or regulate industries and consumers so as to benefit consumers, firms, or government employees.

In doing this, individuals make decisions amidst of limited resources which in other ways is referred to as scarcity of resources. Scarcity means that resources are limited. There are not enough resources available to satisfy everyone’s wants. This is clearly true for individuals. An individual’s income is limited. An individual cannot buy everything they want, so they must choose between different alternatives. The act of choosing the alternative want is known the opportunity cost. The opportunity cost of an action is what one must give up when they make that choice. Another way to say this is: it is the value of the next best opportunity. Opportunity cost is a direct implication of scarcity. People have to choose between different alternatives when deciding how to spend their money and their time. Milton Friedman, who won the Nobel Prize for Economics, is fond of saying ‘there is no such thing as a free lunch.’ What that means is that in a world of scarcity, everything has an opportunity cost. There is always a trade-off involved in any decision you make.

The concept of opportunity cost is one of the most important ideas in economics. However, by considering the question, ‘How much does it cost to go to university for a year?’. We could add up the direct costs like tuition, books and school supplies. These are examples of explicit costs, which is costs that require a money payment. However, these costs are small compared to the value of the time it takes to attend class and do homework. The amount that the student could have earned if she had worked rather than attended school is the implicit cost of attending college. Implicit costs are costs that do not require a money payment. The opportunity cost includes both explicit and implicit costs.

The Theory for the Pricing of Goods and Services

In the real world, the market price is affected by the inventory of goods held by the manufacturers rather than the rate at which manufacturers are supplying goods. If the manufacturers are supplying goods at a rate equal to the consumer demand, the static classical theory would propose that the market is in equilibrium. However, what if there is a tremendous surplus in the store supply rooms? The manufacturers will lower the price and/or decrease production to return inventory to a desired level.

A pricing system model is a description of the relationships leading to price increases and decreases and the effects of these price changes on goal variables and other outcome variables. A system flow diagram is a pictorial representation of an equation system (Forrester, 1961, p.81).

That set of ideas that explains of how relative prices are determined and how prices function to coordinate economic activity is called price theory. There are at least two reasons to want to understand price theory. The first is to make some sense out of the world one live in. individuals are in the middle of a very highly organized system with nobody organizing it. The items they use and see, even very simple objects such as a pen or pencil, were each produced by the coordinated activity of millions of people. Someone had to cut down the tree to make the pencil. Someone had to season the wood and cut it to shape. Someone had to make the tools to cut down the trees and the tools to make the tools and the fuel for the tools and the refineries to make the fuel. While small parts of this immense enterprise are under centralized control (one firm organizes the cutting and seasoning of the wood, another actually assembles the pencil), nobody coordinates the overall enterprise.

The Theory of Economic Welfare

The pre-history of welfare economics is as old as political economics: classical and neo-classical economists were studying the efficiency and equity of productive systems, more specifically wondering how to value commodities or labor, and to assess the best allocation of goods and of tasks for the society (Myint 1965). Utilitarianism which, since Bentham, aimed at providing tools measure and improve individual and collective well-being, may be considered as the genuine root of welfare economics. The definition of welfare was uniformly based on strictly ordinal and subjective individual utilities. The best-known applications are the fundamental theorems of welfare economics.

The first theorem of welfare economics states that competitive equilibria are Pareto-optimal, if individual preferences are monotonic and if there are complete markets. The second fundamental theorem of welfare economics states that one can achieve any Pareto-optimal allocation in a competitive equilibrium when the social planner undertakes an appropriate redistribution of endowments. Among several Pareto optima, some are probably more satisfactory than others. The theorem points out that the preferred social optimum can be achieved by a competitive equilibrium if accompanied by proper redistribution policy which shall establish the new ‘initial’ allocations. An important consequence of this theorem is that it is not necessary to alter the competitive system to obtain Pareto optimality.

It is reasonable to say that Adam Smith (1776) has played an important role in the development of welfare theory. The reasons are at least two. In the first place, he created the invisible hand idea that is one of the most fundamental equilibrating relations in Economic Theory; the equalization of rates of returns as enforced by a tendency of factors to move from low to high returns through the allocation of capital to individual industries by self-interested investors. The self-interest will result in an optimal allocation of capital for society. He writes: “Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of society, which he has in view. But the study of his own advantage naturally, or rather necessarily leads him to prefer that employment which is most advantageous to society”.

The second reason why Adam Smith played an important role in the development of welfare theory is that, in an attempt to explain the ‘Water and Diamond Paradox’, he came across an important distinction in value theory. At the end of the fourth chapter of the first book in Adam Smith’s celebrated volume ‘The Wealth of Nations’ (1776), he brings up a valuation problem that is usually referred to as ‘The Value Paradox’. He writes “The word ‘value’, it is to be observed, has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called ‘value in use’; the other, ‘value in exchange’. The things which have the greatest value in use have frequently little or no value in exchange; and, on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it’.

The Functionality of Microeconomics

A solid foundation microeconomics makes marketing, production management, and finance far easier to master and apply. Price elasticity of demand is much of the subject matter in marketing and marginal analysis will again become central in the methods that individuals use in production management.

As a pure normative science, microeconomics does not try to explain what should happen in a market. Instead, microeconomics only explains what to expect if certain conditions change. If the manufacturer raises the prices of cars, microeconomics says consumers will tend to buy fewer than before. Also if the major copper mine in Zambia collapses, the price of copper increases because supply is restricted.

Although one economist’s model may differ from another’s, a key assumption in most microeconomic models is that individuals allocate their scarce resources so as to make themselves as well off as possible. Of all the affordable combinations of goods, consumers try to maximize their profits given limited resources and existing technology. That resources are limited plays a crucial role in these models. Was it not for scarcity, people rich beyond limit. As shown in the easy, the maximizing behaviour of individuals and firms determines society’s three main allocation decisions: which goods are produced, how they are produced, and who gets them.

Thus many of the models that we examine are based on maximizing an objective that is subject to a constraint. Consumers maximize their well-being subject to a budget constraint, which says that their resources limit how many goods they can buy. Firms maximize profits subject to technological and other constraints. Governments may try to maximize the welfare of consumers or firms subject to constraints imposed by limited resources and the behaviour of consumers and firms.

Conclusion

Microeconomics being the study of the allocation of scarce resources, consumers, firms, and the government must make allocation decisions. The three key trades-offs a society faces are which goods and services to produce, how to produce them, and who gets them. These decisions are interrelated and depend on the prices that consumers and firms face and on government actions. Market prices affect the decisions of individual consumers and firms, and the interaction of the decisions of individual consumers and firms determines market prices. The organization of the market, especially the number of firms in the market and the information consumers and firms have, plays an important role in determining whether the market price is equal to or higher than the cost of producing an additional unit of output. Models based on economic theories are used to predict the future or to answer questions about how some change, such as a tax increase, will affect various sectors of the economy. A good theory is simple to use and makes clear, testable predictions that are not refuted by evidence. Most microeconomic models are based on maximizing behaviour. Economists use models to construct positive hypotheses concerning how a cause leads to an effect. These positive questions can be tested. In contrast, normative statements, which are value judgments, cannot be tested. Individuals, governments, and firms use microeconomic models and predictions to make decisions. For example, to maximize its profits, a firm needs to know consumers’ decision-making criteria, the trade-offs between various ways of producing and marketing its product, government regulations, and other factors. For a large company, beliefs about how its rivals will react to its actions play a critical role in how the company forms its business strategies.

References

Fleurbaey, M. (2008). Fairness, responsibility and welfare. Oxford University Press.
McConnell, Campbell R. and Stanley Brue, (2004). Principles of Economics, sixteenth edition, New York: McGraw-Hill / Irwin.
Friedman, Milton and Rose D Friedman, (1972). Capitalism and Freedom. Chicago: University of Chicago Press.
Debertin David L (1986). Agricultural Production Economics. New York: Macmillan.
Henderson, James M., and R.E. Quandt, (1971). Microeconomic Theory: A Mathematical Approach 2nd Ed. New York: McGraw Hill.
Hicks, J.R. (1932.). Theory of Wages 1st edition, London, Macmillan.
McFadden, Daniel, (1963).”Constant Elasticity of Substitution Production Functions’. Review of Economic Studies 30 pp. 73-83.

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Microeconomics and Its Main Functions

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