By Aidan Hackett. Edited by Arjun Chandrasekar.
Microeconomics is the study of interactions on a small scale – the hint is in the name. By analysing the way consumers and producers interact, microeconomics aims to understand the behaviours of these actors, and the relationship is between supply, demand, and equilibrium. Microeconomics, according to Investopedia, shows how and why different goods have different values, how individuals and businesses conduct and benefit from efficient production and exchange, and how individuals best coordinate and cooperate with one another. These interactions studied in microeconomics are the basis of most other economic studies.
How is Microeconomics “Done”?
When we talk about “doing” microeconomics, we don’t just mean in an academic setting where you have PhD economists discussing advanced statistical models, we also mean everyday people going about everyday life. What we mean is how do people decide to either do or not do something. How do the incentives in the world around them push them to or from participating in certain activities? These questions can be analysed in a normative sense (value judgement/opinion – how should something be done?) and a positive sense (the facts/can be tested – how is it currently done?).
An example of this individual trade-off in action is shopping at a grocery store. You have two options for bananas. The first option costs $3 per kg, is of bad quality, but still consumable without getting sick. The second option costs $4.50 per kg, are prime bananas that are perfectly ripe. Before reading on, consider which banana you would buy. Now, it doesn’t matter which option you chose, but in the process, you probably would have asked yourself some questions, along the lines of “could I afford $4.50 per bunch,” “do I value taste or cost more,” among other things. By doing this process, you just did a microeconomic analysis, albeit on only a single person for a single good.
From this understanding of what microeconomics measures, we can start to develop an understanding of how it is researched. Firstly, we need to understand who the actors are. These are usually a consumer and a producer. Next, we have to understand what their goals are, and what constraints they face. Consumers often have a constraint being money, and time, and usually have the goal of maximising their utility at the lowest possible price. Similarly, producers want to maximise their utility (profit), and are also constrained by the price of the input into their product or service, as well as consumer demand. Lastly, all of these will have coalesced, and a few key assumptions will be made to be put into a model. This model will then be tested. On a side note, the model building process can be described as “theoretical” – building the models, and “empirical” – testing the models.
What does Microeconomics Wish to Achieve?
From the above-listed constraints facing consumers and producers, three key questions are posed. 1, What goods and services should be produced? 2, how do we produce them? and 3, who gets these goods and services?
These questions can all be answered through the consumer-producer interaction in the market for the producer’s product. The outcome of this interaction is the price charged. The price charged is usually (more on this in a bit) a function of the supply and demand, and, in a completely free market, is precisely where the market equilibrium is. By going through the modelling process, microeconomics achieves its goal of finding out where this equilibrium may be.
Where this outcome is most comprehensively achieved is in a perfectly competitive market. While no such market exists in our world, the closest thing is eBay. eBay has a wide range of products and an even wider range of consumers willing to buy them. By listing something for auction on eBay, you can, in real-time, see what the market equilibrium price for that thing is. In the case of a single item, the equilibrium price will just be whatever the highest bidder is willing to pay, so long as it is above the price the seller is willing to sell it for (but realistically this would not be an issue as the minimum price the seller is willing to sell for is usually the price that they start the bidding at). When multiple of the same item is on offer, the equilibrium price is lower. If there are ten items, the equilibrium will be what the tenth most wanting person is willing to pay, for twenty items, it will be the twentieth person’s top price, and so on.
This goal of microeconomics is illustrated very well in Adam Smith’s diamond-water paradox. Simply put, seeing as water is required for survival, why is it priced lower than diamonds. You can live perfectly fine without diamonds. The answer is supply. Sure, people cannot live without water, but the supply of water has always outstripped its demand. Diamonds, on the other hand, are demanded in larger numbers than they are in supply for. Through the interactions of numerous actors in the market, prices for these goods come to an equilibrium.
When is Price not the Answer?
Price is usually the answer and is the natural state of things (in a competitive environment), but in our modern society, other systems are sometimes employed to determine who gets the product (the third question posed).
The first way this can be done is through a “line”. Think about tickets to a concert, or Apple’s new iPhone release, or the release of a Nike x Travis Scott pair of Jordans. The price that these are sold for is well below nth person’s top price for n products. This is done for various reasons (building hype/exclusivity usually). These companies could go and charge thousands of dollars for the product, but they don’t, and as such “lines” form, although these are often online nowadays. Interesting to note, these lines are often filled with people who are going to turn around and sell them at a higher price – the true equilibrium price.
A second way price can be avoided as a determining factor is through external interaction on demand and supply, usually by a government. For one reason or another, in many countries, healthcare is free. This is due to the prevailing, normative idea in those countries, that those who should get healthcare is not those who can afford it, but those who need it most. In these situations, who gets it is a product of need not price.
Microeconomics aims to decipher the inner workings of markets and analyze why people do how they do, but through the lens of incentives, not psychology (see our articles on behavioural economics). By enriching our understanding of price, supply, demand, and equilibrium, basic microeconomic theory provides a diving board, from which we can enter a deeper study of economics.
For more information, we recommend watching this video by Investopedia.