Overview: Microeconomics

What It Means

The field of economics is divided into two basic areas of study: macroeconomics and microeconomics (the prefixes macro and micro are derived from Greek words meaning large and small, respectively). Macroeconomics is the study of whole economies from the top down, with special attention usually paid to large-scale phenomena such as the money supply, unemployment (joblessness), inflation (the general rising of prices), and the economic growth of nations. For instance, the question “What is the effect on the American economy of increasing the amount of money in circulation?” would be very likely to come up in a college class on macroeconomics. Microeconomics, meanwhile, attempts to discover the way that each portion of the economy works; hence it focuses on the decisions of single individuals, business firms, industries, and levels of government. Questions such as “How high can gas prices go before Americans stop buying large automobiles?” are characteristic of microeconomics.

Because an understanding of individual parts of the economy naturally leads to an understanding of the whole economy, there is no clear line indicating where the concerns of microeconomics end and those of macroeconomics begin. Economists use their understanding of microeconomics to help answer macroeconomic questions, and vice versa. While the above question about Americans and gas prices might seem, at first glance, to belong in macroeconomics because it concerns a large group of people and at least two enormous industries, its focus on individual economic decision-making and on specific industries marks it as falling within the domain of microeconomics. This becomes clear if the question is rephrased: “How do individual Americans make decisions regarding high gas prices and large automobiles?” Microeconomic theory provides tools for predicting the behavior of buyers and sellers of gas, automobiles, and every other service and product sold on open markets (a market is any place where buyers and sellers come together to exchange goods and services).

The most basic of these tools, and the foundation for all economic study, are the principles of supply, demand, and pricing. In market economies supply and demand are opposing forces that determine price: a seller’s desire to sell as much of a product as he can at the highest possible price competes against a buyer’s desire to buy that product at the lowest possible price. The resulting market price represents a balancing of the desires of both sides and makes possible the most efficient allocation of resources for all concerned. When supply and demand interact in a pricing system free from distortion, sellers supply exactly as much of a product as buyers demand.

In the real world numerous complicating factors disturb the simplicity of the model outlined above. Economists apply supply and demand and other basic microeconomic principles to various industries and topics, but they usually have to adjust for various complications.

When Did It Begin

The issue of the decisions made by consumers and business firms has been a preoccupation of all economic thinkers since Adam Smith (1723–90) published An Inquiry into the Nature and Causes of the Wealth of Nations (1776), the book credited with establishing economics as a field of study. Smith, a Scottish philosopher, analyzed the interrelationships of supply, demand, and pricing (the concepts at the core of microeconomics), but he emphasized the role of supply in determining prices and quantities of output. The economist most responsible for codifying and popularizing the concepts of supply and demand as they are understood today was Alfred Marshall (1842–1924) of England, whose book The Principles of Economics (1890) was a standard textbook in the field up through the 1950s.

The division of economics into macro and micro disciplines came about in the wake of the theories that the British economist John Maynard Keynes (1883–1946) presented in The General Theory of Employment, Interest, and Money (1936). Keynes offered a way of looking at whole economies that focused on the macro subjects listed in his book’s title, and he suggested techniques whereby governments could affect economic growth on a large scale. As a result of the widespread influence of Keynes’s theories, economists broke from past ideas about employment, interest (fees charged for borrowing money), and money, and they began to solidify the field that came to be called macroeconomics.

No such break from previous theories characterized the simultaneous establishment of microeconomics. Instead, the new label was used to refer to the bottom-up view of the economy made possible by well-established notions such as supply, demand, and pricing.

More Detailed Information

Microeconomic theory focuses on the choices made by individual actors on the economic stage. Choice is necessary because resources are scarce: there is never an unlimited supply of any product or service. The economic decisions that must be made in all societies fall into three basic categories.

Microeconomics provides tools for analyzing how all of these choices are made. The most fundamental of these tools are the laws of supply and demand. The law of supply states that, as the price of a product rises, sellers will be willing to sell more and more of it. The law of demand states that, as the price of a product rises, buyers will be less and less willing to buy it. The competing desires of buyers and sellers, in a market free from distortion, result in what is known as an equilibrium price. At equilibrium the desires of sellers and buyers are balanced, so that supply (the amount of a product produced by sellers) exactly equals demand (the amount of that product desired by buyers).

In a market economy, then, the market itself figures out what will be produced, how it will be produced, and for whom it will be produced. The market does this through the process described above, a process of gauging the opposing desires of the primary decision makers in the economy and encouraging them to make mutually beneficial choices. For instance, it is the combined desires of computer buyers and computer sellers that determine computer prices, and these interrelated forces also dictate virtually every other facet of the computer industry. Supply, demand, and pricing determine how many and what kinds of computers will be produced, the methods according to which computers must be produced, and the rewards that everyone involved in the computer industry stands to gain as a result of this market activity.

Economists use microeconomic analysis to examine real economic situations. They break down real-world market activity according to what they know about supply and demand. Based on past fluctuations of computer-industry supply and demand at various prices, for instance, an economist could offer a prediction about the industry’s future. He or she might be able to tell us how many computers will be needed to satisfy demand in the coming months, what processes of production will be required to allow the industry to be profitable, and what kinds of salaries can be expected in the industry. This information would clearly be useful to investors and businesspeople involved in the computer industry. It would also be useful to the national government, which is charged with overseeing the economic well-being of the country.

Analyzing the basic relationships and decisions in the economy according to the laws of supply and demand is, it should be noted, a necessarily limited approach. The supply-and-demand model is an idealized form of market activity, a market free from distortion and inefficiency. Economists can account for some of the distortion and inefficiency that occurs in real markets. In fact, many of the specialized disciplines within microeconomics have arisen out of the study of particular distortions or out of the study of special cases that depart from the basic supply-and-demand model. Microeconomics cannot ever account for every particularity of the market, however. In any sector of the economy on any given day, the number of choices made, and the reasons that each economic actor made them, are dizzying. It would be all but impossible to record every such decision and motivating factor, much less build any coherent theories based on such an exhaustive portrait of an economic sector.

Microeconomics therefore intentionally simplifies market activity for the purposes of clarity and usefulness. Supply-and-demand theory allows economists to propose models, or simplified versions of real-world market activity, which are often rendered as diagrams. Once economists can model the central forces at work in any portion of the economy, they can predict future changes and encourage rational government policies. Because of the simplification necessary to make the leap from the real world to the realm of theory, there is always uncertainty in any economic prediction. Economists at the highest levels of government and academia frequently disagree on questions about the health of various industries or the economy as a whole.

Certain assumptions or simplifications of reality are particularly crucial to microeconomic analysis. One of these assumptions is that both buyers and sellers act rationally in pursuit of maximum gain. For example, each car buyer wants the lowest price possible for the model he or she wants to buy, and each car company wants to sell as many cars it can at the highest prices possible. Another important assumption that is often central to microeconomics is ceteris paribus (ceteris paribus is Latin for “other things remaining unchanged”), the assumption that everything other than the factor being studied remains constant. For instance, if we were relying on basic supply-and-demand theory to show us what happened when prices across the car industry increased by an average of $1,000 in four months, we might overlook for the moment such factors as consumer taste, assuming for simplicity’s sake that no glaring change in taste occurred during those four months.

Recent Trends

Microeconomic analysis is the foundation of most of the more specialized branches of economics today. These branches include labor economics, which applies supply-and-demand theory to employers and employees, and international economics, which considers supply and demand as it relates to trade between nations. Agricultural economics applies microeconomic tools to the study of agricultural products, land, and labor; while the branch called industrial organization and regulation covers such topics as competition (or lack thereof) between firms, the role of trademarks, and all kinds of government regulations of firms. Public finance considers the role that government intervention (in the form of taxes, laws, and spending programs) plays in markets. The discipline of welfare economics, meanwhile, represents perhaps the most comprehensive use of microeconomic theories among economic subfields. Welfare economics analyzes all forms of economic behavior in an attempt to determine whether market outcomes are beneficial to society as a whole.