Meet Employees A, B and C. A year ago, they were hired at the same wage to work for XYZ Electronics. They typically work about 50 hours a week, and all are due for a raise. Employee A receives a 5 percent wage increase and immediately feels energized by the boost in pay. He decides to commit an additional 10 hours a week to the company to increase his income even further. Employee B receives the same raise, but decides her original 50-hour workweek suits her just fine. She’ll make more money for the same work. For Employee C, however, the pay raise means he won’t have to work as many hours to make his starting income, which is adequate to pay his bills. Therefore, he opts to work only 45 hours a week.
How will the decisions of Employees A, B and C affect the company? Cost-wise, who is the most desirable employee for the company? Do the cost savings offered by Employee C’s reduced hours outweigh the potential profit generated by Employee A’s additional work, or vice-versa? Why is Employee A motivated to work more hours, but Employee C motivated to work fewer? How will this affect their purchasing power as consumers?
Microeconomics seeks to answer questions such as these. The prefix “micro-,” meaning “small,” in the word “microeconomics” refers to the basic, small-scale economic behaviors and decisions that economists in this field study. Microeconomics examines the impact that economic choices made by individuals, businesses and industries have on resource allocation and the supply and demand of goods and services in market economies. Because supply and demand determine the price of goods and services, microeconomics also studies how prices factor into economic decisions, and how those decisions, in turn, affect prices.
Microeconomics emerged as a branch of study when economists began analyzing consumer decision-making processes and their economic outcomes in the early 18th century. The first in-depth explanation of consumer thought came from a Swiss mathematician named Nicholas Bernoulli, who laid the groundwork for microeconomic theory by suggesting that consumer choices are always rational. However, it wasn’t until the late 19th century, when London economist Alfred Marshall proposed examining individual markets and firms as a way to understand the broader economy, that microeconomics became formally established as a field of study.
In the mid 20th century, other economists rose up to modify the theories proposed by Bernoulli and Marshall. Although Marshall first described the concept of utility, or the satisfaction a consumer receives from a purchased product or service, economists John von Neumann and Oskar Morgenstern are credited with introducing modern utility theory, based on Marshall’s work, in 1944.
It’s the concept of market failure, however, that really defined microeconomics in the mid 20th century. Market failure, a term coined in 1958, refers to when markets operate in ways that prevent resources from being allocated in the most efficient manner. Today, microeconomists are primarily concerned with analyzing market failure and suggesting ways to correct or prevent it, often through public policy or government intervention.
Monopoly power is one such market failure. Monopolies can form in several ways. A natural monopoly occurs when one business produces a good at a far cheaper cost than its competitors, causing them to go out of business. In an oligopoly, a few businesses that dominate a particular industry may come together and set prices and competition rules for that industry. A strong business may monopolize by buying up industry resources or controlling means of production and shut competitors out of the market by denying them access. Some governments may simply grant monopoly rights to certain businesses.
Microeconomists see monopolies and other market failures as undesirable and highly inefficient ways to allocate resources in an economy. For instance, a monopoly can choose to charge a higher-than-market-value price for its product because no competition exists that can force it to do otherwise. Consumers who are charged an unfair price are unable to maximize their utility and satisfy demand, either because the product is too expensive for most to afford, or consumers must forgo purchasing other products. If the monopoly’s product is a necessary one, like water or gasoline, consumers may be forced to negatively alter their spending habits to buy it, putting strain on other areas of the economy. Furthermore, a business that has a monopoly on a limited resource may misuse or deplete the resource, damaging both the environment and the economy. Other kinds of market failure include information asymmetry, missing markets and externalities.
Microeconomists believe supply and demand can only be balanced through perfect competition, where no one individual or entity possesses the power to influence the price of a particular good or service. In a perfectly competitive economy, the complete cost of a product is factored into its price, and the product is sold for maximum profit based on its demand. In theory, perfect competition maximizes both consumer utility and company profits while ensuring resources are used in the most efficient manner. Since microeconomists generally aren’t concerned with promoting any sort of political philosophy, they tend to recommend whatever they think will most likely achieve perfect competition. Suggestions may range from anti-trust and right-to-know laws to government-created markets and social welfare expansion.
Unfortunately, such recommendations are rarely foolproof. Because economics involves many complex interactions between various market forces, accurately predicting the outcome of an economic policy is tricky at best, impossible at worst. For example, expanding social welfare may create a safety net that protects workers from economic hard times and promotes upward mobility. The result is a wealthier population that will drive economic growth. However, the same welfare expansion may give some workers an incentive to stop working, which will reduce the government’s income tax revenue and slow economic growth.
Of course, the outcome may not be simply either/or. When offered welfare benefits, some people find incentive to work harder, while others find incentive to work less. The microeconomist’s task is to propose solutions to market failures that will result in the best possible outcomes despite unintended consequences.
To determine the best policies, microeconomists attempt to predict how people will respond to the incentives, or disincentives, such policies will create. For example, an economist sees that a paper company has been clear-cutting too many trees in one area to make paper. For the company, cutting a large number of trees makes sense because it can produce its product quickly at a cheap price that consumers love. However, the economist estimates that if the unrestrained cutting continues, the trees will disappear and the company will go out of business within five years, leaving hundreds of workers unemployed. Construction prices in the area will also skyrocket due to lumber scarcity, and tourism will decline from the destruction of the land’s natural beauty. To prevent these outcomes, the economist suggests the local government should regulate the number of trees that can be harvested at one time.
However, the new regulation means the company won’t be able to produce paper as quickly or cheaply as before, causing its product price to rise. The rise in price means some consumers may not be able to afford the product, or they may choose to buy from another supplier, shrinking the company’s profits. If the company finds the regulation too punitive, it may choose to relocate to another state, resulting in the local unemployment the economist was trying to avoid. The economist can prevent such an outcome by recommending the government provide the company with an incentive to support the regulation, like a tax break.
Of course, such an incentive may not even be necessary. Consumers may happily pay the higher prices and even increase their patronage because they see the company treating the environment responsibly. The company may discover that sticking to cutting quotas protects it from fluctuations in resource availability, leading to greater price stability and steadier profits over time. These outcomes may not become obvious until after the regulation is implemented.
Microeconomists also examine opportunity cost when evaluating consumer and corporate behavior. Opportunity cost refers to the next best alternative a consumer or company passes up to purchase or produce a product. In other words, buying or producing one thing is done at the expense of buying or producing something else. A consumer who chooses to rent an apartment over buying a house, for instance, misses out on building equity and taking advantage of the homeowners tax credit provided by the government. Likewise, a homeowner must provide maintenance for his property’s upkeep, while a renter usually does not.
Examining opportunity costs reveals much about what people value, which guides microeconomists in making policy recommendations. The tricky part comes when such costs involve items whose monetary value is unclear. For instance, some people value preserving the integrity of an Alaskan wildlife refuge over drilling for oil that could be used to lower gasoline prices. Economists must work to establish the refuge’s value so it can be accurately compared to the cost benefit of drilling for oil. Cost-benefit analyses play a major role in microeconomics.
For microeconomists, however, economic behavior always comes back to one concept: utility. Consumers purchase products to increase their satisfaction, and businesses produce to maximize their profits. It’s utility that drives demand and keeps prices reasonable through market competition. Utility can be used to explain why a consumer chooses a to take a tropical vacation over enrolling in college, or why a business chooses to make children’s toys instead of rifle ammunition. The benefit of such a theory is that it’s simple to understand and apply. Indeed, microeconomics provides the foundation for nearly all economic theory and has applications in the fields of health, law, psychology, history, urban development, politics and sociology.