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'''Microeconomics''' is the branch of [[Economics]] that studies the behavior of units called '''''"economic agents"'''''. Microeconomic models investigate assumptions about ''"economic agents"'' activities and about interactions between these agents. An ''"economic agent"'' is the basic unit operating in the model. Most often, we do have in mind that the ''"economic agent"'' is an individual, a person with one head, one heart, two eyes, and two ears. However, in some economic models, an economic agent is taken to be a nation, a family, or a parliament. At other times, the ''"individual"'' is broken down into a collection of economic agents, each operating in distinct circumstances and each regarded as an economic agent. When we construct a model with a particular economic scenario in mind, we might have some ''"degree of freedom"'' regarding whom we take to be the ''"economic agents"''. <ref name=MICROECONOMICS>[http://arielrubinstein.tau.ac.il/Rubinstein-revision.pdf RUBINSTEIN, Ariel. ''Lecture notes in microeconomic theory : the economic agent''. Princeton: Princeton University Press, 2006.]</ref>


Those economic models are instruments or "tools" which help economists better understand the economic reality. As reality is too complex, and has infinite variables  - that cannot be analysed simultaneoulsy - those models make simplifying assumptions about real life. We could compare economic models to geographical maps: the models create a "map" of the economic reality the same way a  map creates a conventional representation of a country. As with maps, no information will come out of an economic model unless it had been previously incorporated in the model by the researcher; this information will only be presented in a more comprehensive manner. It is important to fully understand all the "assumptions" which lie behind any economic model in order to rationally understand their results.


==The basic models of microeconomics==
'''Microeconomics''' is the branch of economics that deals with transactions between suppliers and consumers, acting individually or in groups. It is conventionally defined as being concerned with the allocation of scarce resources among alternative uses, but it is really about such down-to-earth matters as the way consumers' and suppliers' decisions affect the prices and the output of goods and services. Its practical importance arises from the influence of those decisions upon people's well-being. Although it may seem to be about money-related matters, its scope is in fact much wider. It is about how incredibly varied needs and preferences can be met by mutually advantageous transactions.


===Production Possibilities Curves===
Microeconomics attempts to throw light upon real economic activity by first examining the behaviour of simpified representations or ''models'' of the relationships involved, and then  considering the influence of departures from the assumptions adopted in those models.
 
==The nature of economic activity==
Economic activity consists essentially of exchanges that take advantage of the existence of inter-personal differences. If two people have different skills, for example, both can benefit from an arrangement under which each concentrates on what he does best and exchanges what he produces with the other - an arrangement known as the '''''division of labour'''''. At first sight it might seem that each would have to be better than the other at some at some useful activity. In fact that is not necessary. The law of [[comparative advantage]] proves that, even if one them had  an absolute advantage in every type of  activity,  both would  benefit if each person concentrated  upon what he does best and exchanged  the product with the other person. For example, a writer of best-sellers who was better at plumbing than any of  the available plumbers should nevertheless stick to his writing  and hire a plumber. What is true of skill differences is true also of other advantages, such as the possession of different tools or access to more fertile land. (And what is true of persons is true also of countries, making comparative advantage the driving force of international trade.)


The ''production possibility curve'' <ref name=PRODPOSS>[http://www.chass.utoronto.ca/~reak/eco100/shift.swf '''Production Possibility Curve''' <small>Animated graph</small>]</ref> is a hypothetical representation of the amount of two different goods that can be obtained by shifting resources from the production of one good to the production of the other. It is "strictly hypothetical" and "static" in nature. The curve is used to represent a society’s choice between two different goods. A society can use up all its potential resources producing a lot of butter and no guns at all. Or can use most of its resources producing guns and no butter. Between those to extremes there are infinite combinations of possibilities for production of guns and butter that can be choosed by society. <ref name=PRODUCPOSSIB>[http://krypton.mnsu.edu/~renner/ppc.htm '''Production Possibility Curves''']</ref><small>See graphs at the links</small>
In examining production and consumption  as though they are separate  activities it is important to remember that in reality they are interdependent, and  that neither can survive without the other. (The fact that they are usually connected by monetary transactions is, strictly speaking, irrelevant.  In microeconomic activity money serves only as convenient measuring-stick - unlike the more important part it plays in macroeconomics.)  Microeconomics, like macroeconomics, is the study of an interactive system  which can yield misleading conclusions if  any individual  component is considered in isolation.


Any two different goods could be chosen arbitrarily. This is one of the "assumptions" for this economic model. The curve, (plotted on a X-Y axis) shows graphically, during a specific period of time (another assumption), which combined quantities of both goods could be produced, "if all resources are fully employed" (another assumption), while "technology and institutions do not change" (yet another assumption). Given those "hypotetical" conditions, society's "output potential" for those two goods combined is realized anywhere on the curve (which is called the "production possibility curve’s frontier"). Any point on the "production curve" represents the maximum output possible for both commodities. (mathematically all points in the curve represent the "locus" of the maximum possible combination of output for both goods simultaneoulsy). <ref name=PRODUCPOSSIB>[http://krypton.mnsu.edu/~renner/ppc.htm '''Production Possibility Curves''']</ref><small>See graphs at the links</small>
==Production==
The '''''factors of production''''' are normally taken to include:
* land - taken to mean all natural resources - and otherwise distinguished from the other factors by the fact that its supply cannot be increased;
* labour - taken to cover both the number of people engaged in production and the aggregate of their productive abilities;
* capital - taken to mean assets which have been produced for use in production.
(some economists also take entrepreneurship to be a factor)


Any "unemployed" resources by society, such as labor, capital, or physical resources would cause society to remain in an "inefficient production level". This would be shown in the graph as a point to the left, (or inside) the curve. (So, when some people are unable to find a job, society is not reaching its "most efficient level of production" and the whole of society pays a price for that unemployment). By definition all point to the right (or outside) of the production possibility curve (frontier) are impossible to be attained, given the limits of existing resources and technology (another assumprion).


====Assumptions used for the construction of this economic model====
Economists have created a number of generalisations about the relations between the uses of the factors of production and the output that results.
* '''diminishing returns''' refers to the observation that if one only of the factors is progressively increased, '''leaving the others unchanged''', output rises, at first in proportion, but subsequently less than proportionately to the rising input. For example,  although doubling the number of workers on a building site might get the job done twice as fast, it does not follow that trebling that number would get it done three times as fast.
* '''returns to scale''' refers to the observation that a simultaneous increase in all of the factors of production will often lead to a more than proportionate increase in output. If a retailer increases the number of his outlets he can often make more economical use of his warehousing and distribution facilities.
*the '''production possibility frontier''' is the limiting set of output combinations of a multi-product firm. Textbooks usually deal with the simplest two-product case, which they illustrate with a diagram. For a car manufacturer that also produces tractors, the diagram  depicts a situation in which car output has to fall faster and faster if tractor output is to be increased.  The diagram illustrates the useful concept of an '''opportunity cost'''. For the car manufacturer working at a given output combination, the opportunity cost of making one more tractor is the reduction in car output that would be needed.


* Any two different goods could be chosen arbitrarily;
* Production takes place during a specific period of time;
* All resources are fully employed;
* Technology and institutions do not change, and
* All points to the right (or outside) of the "production possibility curve" (frontier) are impossible to be attained.


We will never find all of those conditions in real life. However they represent a "reasonable scenario" which allows economists to reduce the number of variables in the problem and better analyse the phenemenon.
Logic requires that the output of a profit-maximising firm has to be at such a level  that the production of one additional unit would bring in as much revenue as it would  cost to produce. Economists usually state that condition as '''marginal revenue must equal marginal cost'''.  That is one of the theorems of '''[[the theory of the firm]]''' and the concept of marginal cost plays an important part elsewhere in the study of microeconomics.


::<small><This article is under construction></small>
The term '''externality''' refers to the cost of a product that is borne by someone other than its producer. A factory with a smoking chimney, for example, imposes health costs upon nearby residents.


===Demand Functions and Demand Curves===
==The consumer==


The demand for any good is the amount consumers want to buy and are able to buy in a particular period of time. The basic model of demand says that the amount demanded of any good depends on the good's own price, consumer income, the prices of substitutes and complements, consumer preferences, and perhaps other factors (assumptions for this model).  
Economists refer to the  desirability of a product  to a consumer  as its  '''utility'''. The '''marginal utility''' of a product, which is the notional increase in a person's utility that he or she would get by receiving one more unit of that product, is a concept of particular importance in microeconomic theory.  A consumer's '''indifference curve''' depicts a set of combinations  of two products that is so constructed that, at each combination, the consumer would get an equal increment of utility from one more unit of either product.  It can be thought of as the consumer’s counterpart of the production possibilities curve, above, and it  is similarly a two-dimensional  simplification of  what is really a multi-dimensional situation. The slope of the indifference curve at a given point represents what is termed the consumer's '''marginal rate of substitution''' between the two products at that point. If, when in possession of a particular combination of apples and pears, a consumer is willing to give up an apple in exchange for two pears, then that is his marginal rate of substitution of apples for pears. The marginal rate of substitution can also be seen as the ratio of the marginal utilities of the two products.


====A most basic example====
The amount of a product that a consumer is prepared to buy  is influenced also by its price  and by what he  can afford. A consumer's response to changes of price is referred to as his '''price elasticity of demand''', which is the percentage increase in the amount he would be prepared to buy in response to a one percent reduction in price.  His response to changes in  income  is referred to as his '''income elasticity of demand''', which is the percentage increase in the amount he would be prepared to  buy in response to a one percent increase in his income. The demand for a product is also affected by changes in the prices of substitutes and the term '''cross-elasticity of substitution''' is used to mean the percentage increase in the demand for a product resulting from a one percent cent increase in the price of a substitute.


Imagine that a fruit merchant, Mr. Wilson, used to mark down how many oranges his client, Mrs Smith, buys at his shop every week. He noticed that as the price of oranges varies during the year, Mrs. Smith buys more or less oranges from him.  
In the terminology of microeconomics, the term ''social utility'' refers to the notional total utility of a product to a community, and the term ''social cost'' refers to the total that the community has to pay for a product, plus any social utility that is lost as a result of externalities such as the noise and pollution generated in the course of its production.


*If oranges cost 5 cents  each > Mrs Smith buys 10 oranges
==Markets==
*If oranges cost 4 cents  each > Mrs Smith buys 17 oranges
When a consumer makes a deal with a producer, the outcome depends upon what other producers there are, and how they behave. If there were only a single producer, the outcome would be different from what it would be if there were a '''market''' of competing producers. In such a market, the most important factor would be the intensity of their '''[[competition]]'''.
*If oranges cost 3 cents each > Mrs Smith buys 26 oranges
*If oranges cost 2 cents each > Mrs Smith buys 38 oranges
*If oranges cost 1 cents  each > Mrs Smith buys 53 oranges


By drawing an x-y graph and ploting those results into the graph, we will have a "demand curve for oranges" showing Mrs. Smith's preference schedule. <small> (By convention the demand curve displays quantity (oranges) as the independent variable (the x axis - horizontal ) and price (cents) as the dependent variable (the y axis- vertical)</small>. This curve is a "portrait" that represents the "demand" for oranges (by Mrs. Smith, at Mr. Wilson shop). <ref name=DMNDCRVSMPL>[http://www.netmba.com/econ/micro/demand/curve/ Demand Curve (very simple)]</ref><small> <See graph at the link></small>
At one end of the spectrum of possibilities is the hypothetical concept of '''pure (or perfect) competition''' – a situation in which no single producer could influence the market price. The outcome in that case would be as though the consumer – and all the other consumers - were negotiating simultaneously with every producer in the market. It would be as though various prices were tried until the process arrived at the '''market-clearing price'''  –  the price at which  the amount  offered for sale matches the amount that  people are prepared to buy . Then anyone attempting to buy the product at a lower price would find no sellers and anyone attempting to sell the product at a higher price would find no buyers. If producers had been seeking to maximise their profits, the market price of the product would be the industry’s '''marginal cost''' of producing it. (That follows from the requirement stated above that marginal revenue must equal marginal cost because when price is constant it is the same as marginal revenue.)


From this simple schedule the fruit dealer drew an important conclusion: "the demand for oranges increases as its price drops, and drops as its price increases". He might not have been aware of one fact, however: to draw this conclusion he made a very important "assumption": "all other factors remaining constant". If, for instance, Mrs, Smith was giving a party the day she bought 53 oranges at 1 cent each, (and that particular day would have bought 53 oranges even if the price was at 5 cents) the conclusions of Mr. Smith "demand function" would be worthless. Mr Smith also noticed some other things that puzzle him: his client Mr. Bernstein never buys any orange, no matter how cheap they get. And Mr. Gates, his millionaire customer, always takes home two dozen oranges, doesn't matter if they are cheap or very expensive. Why is that so? Mr. Smith keeps asking himself those questions, without finding an answer.
At the other end of the spectrum is the absence of competition, known as '''monopoly'''. A monopoly producer has a degree of control over price – although, of course, the higher his price, the smaller will be his sales. That means that the revenue from the sale of an additional unit will be  less than its  price (because to sell an additional  unit he would have to reduce his price). To fulfil the profit-maximising requirement that marginal revenue must equal marginal cost, he must therefore raise his price above his marginal cost and accept lower sales.


====Assumptions used by Mr. Smith (implicitly) in this economic model====
Between those hypothetical extremes is the everyday world of '''imperfect competition'''. In that world, every supplier has some degree of control over the price that he can charge. In the terminology of economics, the degree of control over price that a firm enjoys is its '''market power'''. And the greater a firm's market power, the higher will be its profit-maximising price. The size of a firm's share of a market usually provides a rough measure of its market power in that market.


* ALL other factors remain equal
==Inefficiencies==
* This demand function reflects the "consumer preference" of a single customer, Mrs Smith's.


====A more realistic scenario====
While markets are the most efficient means for distributing goods, not all markets are efficient. This can be either because of the market structure or because of government intervention.


For example, one could build an schedule showing a hypothetical demand curve for spaghetti in San Francisco, measured in plates per day. Demand depends on the price of spaghetti, average annual
===Taxes and Subsidies===
money income of consumers, the price of tacos, and the price of wine (assumptions). You may build your own spreadsheet, place all those variables on it as "parameters"  and see how demand varies. (Or you may use this link to an already built spreadsheet; all of the
prices and income and the spaghetti demand will be updated. The graph of the demand curve wil be redrawn to show the effects of your changes.) <ref name=SPAG>[http://www.msu.edu/course/ec/201/brown/xlfiles98/demand98.xls Demand Curves, a live exercise <small> Requires "Firefox" or Netscape", requires "Excel 97" or higher. Enable macros</small>]</ref><small> <See live graph at the link></small>


Economists make a distinction between the effects on the amount demanded of changing a "good's own price", and the effects on the amount demanded when one of the other determinants of demand varies, such as "income". When a good's own price changes, consumers "move along" a particular demand curve. When any other determinant changes, the "demand curve
Inefficiency (measured by the [[deadweight loss]], or loss of total welfare) results from decreased or increased purchasing. This is somewhat complicated to understand, but the graph on the right will be very helpful. Basically what a tax does is it increases the price paid by the consumer and decreases the price received by the seller. This results in a lower quantity demanded, a lower quantity sold, and lower welfare in general. While the government does enjoy increased welfare due to tax revenue, there is still a measurable difference in total welfare. While this is fairly straightforward, the inefficiency resulting from a subsidy is a little harder to grasp. Consumer Welfare is the area below the demand curve but above the equilibrium price, and Supplier Welfare is the area above the supply curve but below the equilibrium price. Opposite of a tax, the surplus will decrease the price paid and increase the price received, but at a great cost (the size of the surplus multiplied by the total quantity of goods sold). In the end, Consumer and Supplier surpluses don't work out to a high enough value to offset the government's loss of welfare, resulting in a deadweight loss. Check out the tutorial section for graphs if any of this is confusing... they should be fairly helpful
shifts", as can be seen on the live graph when "income" is changed. <ref name=SPAG>[http://www.msu.edu/course/ec/201/brown/xlfiles98/demand98.xls Demand Curves, a live exercise <small> Requires "Firefox" or Netscape", requires "Excel 97" or higher. Enable macros</small>]</ref><small> <See live graph at the link></small> Changes in a good's own price are said to cause a "change in quantity demanded", while changes in other factors are said to cause a "change in demand".  


=====Assumptions used in this model=====
==Public Goods==
The category of products termed [[Public Goods]] comprises those whose provision has to  be decided by the community as a whole, rather than by transactions between producers and individual consumers. Within that category are such products as defence and law enforcement, and in a related category there are products in which there is some degree of community involvement, such as health and education.


* The amount demanded of any good depends on the good's own price, consumer income, the prices of substitutes and complements, consumer preferences, and perhaps other factors such as weather;
==How it works out in theory==
* The consumer is absolutely rational and has an almost infinite desire for the good considered; in this case he likes spaghetti a lot. So, if the price of spaguetti keeps falling, he will always eat more and more spaguetti.
The concept of a perfectly competitive market is far removed from reality. Among its unrealistic assumptions are the assumption that all consumers make rational choices, that those choices are based upon totally accurate information about the products available in each of the existing markets, and that in each product market all the producers supply identical products.  Nevertheless, economists  have used an analysis of fully competitive markets as a basis for their exploration of microeconomic activity, and the further concepts that have emerged have had a powerful influence upon subsequent economic thought. Among the more important of those concepts is that of '''[[economic efficiency]]'''. Defined more fully in the article on the subject, economic efficiency is essentially about the contribution of economic activity to the welfare of the community. The concept of welfare that this involves is further developed in the article on '''[[welfare economics]]''', but what the welfare of an individual  really amounts to is how well-off that individual feels – and community welfare is some sort of aggregation of those feelings. It is shown in the articles on welfare and efficiency that the most efficient output of any product occurs when its marginal social utility is equal to its marginal social cost, that the most efficient allocation of the factors of production as between different products occurs when that requirement is met by all products, and that that requirement would be met in an economy consisting of perfectly competitive markets. Suppliers of public goods are not subject to market forces, but their behaviour can often be regulated in the interests of economic efficiency by the application of microeconomic principles.  
{{main|Supply and demand}}


===Supply Functions and Supply Curves===
From the starting-point of perfectly competitive markets, a great deal of theoretical work has gone into the behaviour of profit-maximising suppliers under conditions of imperfect competition, but no straightforward answers have emerged. Analysis of such markets has been complicated by the need to postulate how each supplier reacts to the likely behaviour of his competitors, and to differences in their cost structures.


===Equilibrium Prices===
==Practical implications==
The theory that has been outlined establishes that an economy consisting of perfectly competitive markets would necessarily produce the optimal combination of products, thus satisfying one of the conditions for economic efficiency. It is – to say the least – questionable whether it is safe to conclude that competitive conditions necessarily favour economic efficiency. Nevertheless, that is the broad presumption adopted by most practising economists. Their policy prescriptions include the removal of barriers to competition where that is possible and the regulation of monopoly behaviour where it is not. The adoption of that presumption, despite the unrealism of its underlying assumptions, has been defended on the grounds that the value of analysis depends not upon the realism of its assumptions but upon its ability to yield useful results <ref> Milton Friedman '' Essays in Positive Economics'' pages 18 to 39 Phoenix Books 1966 </ref> but that has been contested by economists of the [[Austrian School]] <ref> Stephen Littlechild ''The Fallacy of the Mixed Economy'' Hobart Paper No 80 Institute of Economic Affairs 1986 </ref>.


===Labor Markets===
Outside of their involvement with [[business economics]] and [[competition policy]] the principal microeconomic activity of practising economists is the [[cost/benefit analysis]] of activities that lie outside the scope of market economics. That includes the provision of public goods and the regulation of the activities of ''natural monopolies''.
 
===Elasticity of Demand===
 
===Consumer and Producer Surplus===
 
===Taxes and Welfare===
 
===Trade and Welfare===
 
===Externalities===
 
===Production Functions & Isoquants===
 
===Cost Minimization===
 
===Marginal Products and Minimizing Cost===
 
===Production and Cost in the Short-Run===
 
===Total, Average, and Marginal Cost===
 
===Profit Maximization for the Competitive Firm===
 
===Competitive Markets in the Short-Run===
 
===Competitive Markets in the Long-Run===
 
===Monopoly===
 
===Natural Monopoly===
 
===Price discrimination===
 
===Utility Functions and Indifference Curves===
 
===Utility Maximization===
 
===Demand Curves, and Income and Substitution Effects===
 
===Marginal Utility and Optimization===
 
===Discounted Present Value===
 
===Internal Rate of Return===
 
===Comparative Advantage===
 
===Labor Demand for the Competitive Firm===
 
===Competitive Labor Markets===
 
==See also==
 
*[[Economics]]
*[[Macroeconomics]]
*[[Economic Theory]]


==References==
==References==
<div class="references-small" style="-moz-column-count:2; column-count:2;"><references /></div>
<references/>
 
==External Links==
<div class="references-small" style="-moz-column-count:2; column-count:2;">
 
* [http://www.msu.edu/course/ec/201/brown/pim/ '''''MICROECONOMICS: Most important concepts explained in detail'''''. Text and workable problems. <small>'''WARNING: Internet Explorer will not work!''' Get "Firefox" or "Netscape". Requires "Adobe Acrobat Reader" as a helper to your web browser. You will need "Excel 97" or higher running on your computer to use the spreadsheets.</small>]
 
* [http://www.helsinki.fi/WebEc/ ''World Wide Web Resources in Economics''.  Center for Innovative Education, Helsinki School of Economics, Finland. (An excellent sorce of links to the various Economics subdisciplines)]
 
</div>
 
[[Category:CZ Live]]
[[Category:Economics Workgroup]]

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Microeconomics is the branch of economics that deals with transactions between suppliers and consumers, acting individually or in groups. It is conventionally defined as being concerned with the allocation of scarce resources among alternative uses, but it is really about such down-to-earth matters as the way consumers' and suppliers' decisions affect the prices and the output of goods and services. Its practical importance arises from the influence of those decisions upon people's well-being. Although it may seem to be about money-related matters, its scope is in fact much wider. It is about how incredibly varied needs and preferences can be met by mutually advantageous transactions.

Microeconomics attempts to throw light upon real economic activity by first examining the behaviour of simpified representations or models of the relationships involved, and then considering the influence of departures from the assumptions adopted in those models.

The nature of economic activity

Economic activity consists essentially of exchanges that take advantage of the existence of inter-personal differences. If two people have different skills, for example, both can benefit from an arrangement under which each concentrates on what he does best and exchanges what he produces with the other - an arrangement known as the division of labour. At first sight it might seem that each would have to be better than the other at some at some useful activity. In fact that is not necessary. The law of comparative advantage proves that, even if one them had an absolute advantage in every type of activity, both would benefit if each person concentrated upon what he does best and exchanged the product with the other person. For example, a writer of best-sellers who was better at plumbing than any of the available plumbers should nevertheless stick to his writing and hire a plumber. What is true of skill differences is true also of other advantages, such as the possession of different tools or access to more fertile land. (And what is true of persons is true also of countries, making comparative advantage the driving force of international trade.)

In examining production and consumption as though they are separate activities it is important to remember that in reality they are interdependent, and that neither can survive without the other. (The fact that they are usually connected by monetary transactions is, strictly speaking, irrelevant. In microeconomic activity money serves only as convenient measuring-stick - unlike the more important part it plays in macroeconomics.) Microeconomics, like macroeconomics, is the study of an interactive system which can yield misleading conclusions if any individual component is considered in isolation.

Production

The factors of production are normally taken to include:

  • land - taken to mean all natural resources - and otherwise distinguished from the other factors by the fact that its supply cannot be increased;
  • labour - taken to cover both the number of people engaged in production and the aggregate of their productive abilities;
  • capital - taken to mean assets which have been produced for use in production.

(some economists also take entrepreneurship to be a factor)


Economists have created a number of generalisations about the relations between the uses of the factors of production and the output that results.

  • diminishing returns refers to the observation that if one only of the factors is progressively increased, leaving the others unchanged, output rises, at first in proportion, but subsequently less than proportionately to the rising input. For example, although doubling the number of workers on a building site might get the job done twice as fast, it does not follow that trebling that number would get it done three times as fast.
  • returns to scale refers to the observation that a simultaneous increase in all of the factors of production will often lead to a more than proportionate increase in output. If a retailer increases the number of his outlets he can often make more economical use of his warehousing and distribution facilities.
  • the production possibility frontier is the limiting set of output combinations of a multi-product firm. Textbooks usually deal with the simplest two-product case, which they illustrate with a diagram. For a car manufacturer that also produces tractors, the diagram depicts a situation in which car output has to fall faster and faster if tractor output is to be increased. The diagram illustrates the useful concept of an opportunity cost. For the car manufacturer working at a given output combination, the opportunity cost of making one more tractor is the reduction in car output that would be needed.


Logic requires that the output of a profit-maximising firm has to be at such a level that the production of one additional unit would bring in as much revenue as it would cost to produce. Economists usually state that condition as marginal revenue must equal marginal cost. That is one of the theorems of the theory of the firm and the concept of marginal cost plays an important part elsewhere in the study of microeconomics.

The term externality refers to the cost of a product that is borne by someone other than its producer. A factory with a smoking chimney, for example, imposes health costs upon nearby residents.

The consumer

Economists refer to the desirability of a product to a consumer as its utility. The marginal utility of a product, which is the notional increase in a person's utility that he or she would get by receiving one more unit of that product, is a concept of particular importance in microeconomic theory. A consumer's indifference curve depicts a set of combinations of two products that is so constructed that, at each combination, the consumer would get an equal increment of utility from one more unit of either product. It can be thought of as the consumer’s counterpart of the production possibilities curve, above, and it is similarly a two-dimensional simplification of what is really a multi-dimensional situation. The slope of the indifference curve at a given point represents what is termed the consumer's marginal rate of substitution between the two products at that point. If, when in possession of a particular combination of apples and pears, a consumer is willing to give up an apple in exchange for two pears, then that is his marginal rate of substitution of apples for pears. The marginal rate of substitution can also be seen as the ratio of the marginal utilities of the two products.

The amount of a product that a consumer is prepared to buy is influenced also by its price and by what he can afford. A consumer's response to changes of price is referred to as his price elasticity of demand, which is the percentage increase in the amount he would be prepared to buy in response to a one percent reduction in price. His response to changes in income is referred to as his income elasticity of demand, which is the percentage increase in the amount he would be prepared to buy in response to a one percent increase in his income. The demand for a product is also affected by changes in the prices of substitutes and the term cross-elasticity of substitution is used to mean the percentage increase in the demand for a product resulting from a one percent cent increase in the price of a substitute.

In the terminology of microeconomics, the term social utility refers to the notional total utility of a product to a community, and the term social cost refers to the total that the community has to pay for a product, plus any social utility that is lost as a result of externalities such as the noise and pollution generated in the course of its production.

Markets

When a consumer makes a deal with a producer, the outcome depends upon what other producers there are, and how they behave. If there were only a single producer, the outcome would be different from what it would be if there were a market of competing producers. In such a market, the most important factor would be the intensity of their competition.

At one end of the spectrum of possibilities is the hypothetical concept of pure (or perfect) competition – a situation in which no single producer could influence the market price. The outcome in that case would be as though the consumer – and all the other consumers - were negotiating simultaneously with every producer in the market. It would be as though various prices were tried until the process arrived at the market-clearing price – the price at which the amount offered for sale matches the amount that people are prepared to buy . Then anyone attempting to buy the product at a lower price would find no sellers and anyone attempting to sell the product at a higher price would find no buyers. If producers had been seeking to maximise their profits, the market price of the product would be the industry’s marginal cost of producing it. (That follows from the requirement stated above that marginal revenue must equal marginal cost because when price is constant it is the same as marginal revenue.)

At the other end of the spectrum is the absence of competition, known as monopoly. A monopoly producer has a degree of control over price – although, of course, the higher his price, the smaller will be his sales. That means that the revenue from the sale of an additional unit will be less than its price (because to sell an additional unit he would have to reduce his price). To fulfil the profit-maximising requirement that marginal revenue must equal marginal cost, he must therefore raise his price above his marginal cost and accept lower sales.

Between those hypothetical extremes is the everyday world of imperfect competition. In that world, every supplier has some degree of control over the price that he can charge. In the terminology of economics, the degree of control over price that a firm enjoys is its market power. And the greater a firm's market power, the higher will be its profit-maximising price. The size of a firm's share of a market usually provides a rough measure of its market power in that market.

Inefficiencies

While markets are the most efficient means for distributing goods, not all markets are efficient. This can be either because of the market structure or because of government intervention.

Taxes and Subsidies

Inefficiency (measured by the deadweight loss, or loss of total welfare) results from decreased or increased purchasing. This is somewhat complicated to understand, but the graph on the right will be very helpful. Basically what a tax does is it increases the price paid by the consumer and decreases the price received by the seller. This results in a lower quantity demanded, a lower quantity sold, and lower welfare in general. While the government does enjoy increased welfare due to tax revenue, there is still a measurable difference in total welfare. While this is fairly straightforward, the inefficiency resulting from a subsidy is a little harder to grasp. Consumer Welfare is the area below the demand curve but above the equilibrium price, and Supplier Welfare is the area above the supply curve but below the equilibrium price. Opposite of a tax, the surplus will decrease the price paid and increase the price received, but at a great cost (the size of the surplus multiplied by the total quantity of goods sold). In the end, Consumer and Supplier surpluses don't work out to a high enough value to offset the government's loss of welfare, resulting in a deadweight loss. Check out the tutorial section for graphs if any of this is confusing... they should be fairly helpful

Public Goods

The category of products termed Public Goods comprises those whose provision has to be decided by the community as a whole, rather than by transactions between producers and individual consumers. Within that category are such products as defence and law enforcement, and in a related category there are products in which there is some degree of community involvement, such as health and education.

How it works out in theory

The concept of a perfectly competitive market is far removed from reality. Among its unrealistic assumptions are the assumption that all consumers make rational choices, that those choices are based upon totally accurate information about the products available in each of the existing markets, and that in each product market all the producers supply identical products. Nevertheless, economists have used an analysis of fully competitive markets as a basis for their exploration of microeconomic activity, and the further concepts that have emerged have had a powerful influence upon subsequent economic thought. Among the more important of those concepts is that of economic efficiency. Defined more fully in the article on the subject, economic efficiency is essentially about the contribution of economic activity to the welfare of the community. The concept of welfare that this involves is further developed in the article on welfare economics, but what the welfare of an individual really amounts to is how well-off that individual feels – and community welfare is some sort of aggregation of those feelings. It is shown in the articles on welfare and efficiency that the most efficient output of any product occurs when its marginal social utility is equal to its marginal social cost, that the most efficient allocation of the factors of production as between different products occurs when that requirement is met by all products, and that that requirement would be met in an economy consisting of perfectly competitive markets. Suppliers of public goods are not subject to market forces, but their behaviour can often be regulated in the interests of economic efficiency by the application of microeconomic principles.

From the starting-point of perfectly competitive markets, a great deal of theoretical work has gone into the behaviour of profit-maximising suppliers under conditions of imperfect competition, but no straightforward answers have emerged. Analysis of such markets has been complicated by the need to postulate how each supplier reacts to the likely behaviour of his competitors, and to differences in their cost structures.

Practical implications

The theory that has been outlined establishes that an economy consisting of perfectly competitive markets would necessarily produce the optimal combination of products, thus satisfying one of the conditions for economic efficiency. It is – to say the least – questionable whether it is safe to conclude that competitive conditions necessarily favour economic efficiency. Nevertheless, that is the broad presumption adopted by most practising economists. Their policy prescriptions include the removal of barriers to competition where that is possible and the regulation of monopoly behaviour where it is not. The adoption of that presumption, despite the unrealism of its underlying assumptions, has been defended on the grounds that the value of analysis depends not upon the realism of its assumptions but upon its ability to yield useful results [1] but that has been contested by economists of the Austrian School [2].

Outside of their involvement with business economics and competition policy the principal microeconomic activity of practising economists is the cost/benefit analysis of activities that lie outside the scope of market economics. That includes the provision of public goods and the regulation of the activities of natural monopolies.

References

  1. Milton Friedman Essays in Positive Economics pages 18 to 39 Phoenix Books 1966
  2. Stephen Littlechild The Fallacy of the Mixed Economy Hobart Paper No 80 Institute of Economic Affairs 1986