Introduction to Microeconomics

 
Economics, though largely perceived as a theoretical and dry subject has a banal connection with science (or spirituality?): presence of duality. It is the study of ‘individual’ decisions as well as the overall reality emerging from the inter-play of these infinitely complex interactions.

Microeconomics deals with the ‘individual’ part of this duality – the rationality behind the decisions of an individual given the constraints of limited resources.

By definition, microeconomics is concerned with the interaction of an economic agent (buyer/seller) with the market, push/pull of supply and demand and the resultant swings in prices, production and output.

The science of economics inherited a legacy from institutions that arose because of the specialization of labor – every entity engaged in a specialized activity and engaging in trade afterwards for unfulfilled needs.

Microeconomics takes the rational economic individual at center stage – one who seeks to maximize the “utility” from every economic transaction.
 

Importance of Microeconomics

The fundamentals of microeconomics originate from a basic human characteristic: unlimited desires with limited resources. Consumer spending is a major chunk of the modern economy, and understanding consumer behavior at the micro-level is all the more important to recognize the individual spending and saving patterns.

Each and every decision also entails eschewing other alternative paths – and the cost associated with every lost alternative is termed the opportunity cost.

One of the main goals of studying microeconomics is to increase economic efficiency, and charity might literally begin at home when it comes down to this. It will have different forms and shapes, and it definitely encompasses more than the industrial archetype of producing most output from least input:

    • Allocative efficiency: The paradigm of allocative efficiency assumes that producers are only supplying goods that the market wants, i.e. products which are in high demand. In mathematical terms, it is the point at which price is equal to the marginal cost (the cost of producing one more unit of a particular produce). Some allocations are inherently better than others in terms of the net effect (the positives outweigh the negatives). It is usually defined using Pareto Optimality (or Superiority) – a situation where no person could be made better off without harming someone else.
    • Technical efficiency: When we talk of efficiency in terms of the productiveness with which we obtain an output with a certain set of inputs, we are talking about technical efficiency. An alternative way of looking at it is through X-efficiency – the level of efficiency in the case of imperfect competition. For instance, a monopolist might not upgrade machinery because of the absence of sufficient incentives.
    • Employment: Human labor is one of the most important resources which need effective utilization – “almost” full employment is required for a system to be called economically efficient.

Another aspect of microeconomics which manifests in a much more glaring form is the politico-economic system of a country.

  • Pure capitalism espouses private ownership of property and production and the role of government is minimal, mostly ensuring “fair-play” among the participants. It is centered on the idea of self-interest and hypothesizes that resources automatically get assigned to places where they are most effectively utilized. A common problem with current capitalistic systems is that we still don’t know how much government intervention is too much! It results in huge income inequalities and social ills over a period of time [some mind munching: why do some people hate the US?]
  • Pure socialism is much more concerned with perceived equity among citizens than anything else (growth often takes a backseat as an unintended consequence). The government has control over production in many key areas and can impose tariffs or introduce subsidies to artificially alter markets [note: India was a socialist state from independence till 1991 and it was a sad state of affairs. Why do noble ideas of socialism fail practicality tests?]
  • Communism does not allow any kind of private property and supposedly everyone has an equal share in the output of society. The basic idea of communism propounded by Karl Marx became an ideal — almost all the implementations got corrupt at some level due to the inevitable ‘human’ element present at the top of the hierarchy [read about Orwellian ‘Big Brother’ to get a hang of the forces at the top in a totalitarian society]. It is almost antithetical to capitalism, and any semblance to faith in the base idea of ‘self-interest’ is thrown out the window. Pure communism is largely ideal and has failed to deliver so far in most of the cases, as we discover that people do respond to personal incentives in the end.

 

Scope of Microeconomics

The fundamental assumption in Microeconomics is that an individual has unlimited desires and a limited budget, while the available resources are allocated in a way which maximizes the overall benefit or happiness. Happiness as a metric is abstract and very hard to measure from the economists’ point-of-view. It is exchanged with a relatively less abstract term in a microeconomic sense: utility.

Utility is the perceived benefit or “happiness” one receives from a particular good. As the concept of utility is relative and will mean different things for different people, economists measure it in terms of available economic choices (the mathematical unit used to measure utility is utils).

In other terms, we can say that it is a reflection of the proclivity of the end consumer towards a particular good. Though this calculation is mostly arbitrary and depends on the school of thought one belongs to, it still gives a peek into the complexities that are inherent in the buying decisions of the consumer.

The aggregated numerical data may not be absolutely correct at the user level, but it still goes a long way in influencing the decisions of major corporates in terms of the product assortment, manufacturing schedules and prices. In a world dented by consumerism, even directional information on consumer choices is vital for corporations.

One limitation of the utility theory is that it assumes that the end customers always behave in a cold-rational-logical manner, which is simply not true.

Behavioral economics is a relatively “new field” that is a blend of psychology and economics and points at the asymmetries and biases in the psychology of the economic agent (quick book recommendation: ‘Predictably Irrational’ by Dan Ariely).
 

Microeconomics: Decisions and Trade-offs

  • Price of a good is largely a function of the supply and demand. The demand of a good goes down as the price increases, all the remaining factors being equal. Price is definitely one of the major factors influencing consumer decisions.
  • If a consumer gives up one thing to buy another, the trade-off involved is the opportunity cost. The opportunity cost of going for a two-year MBA is the money you would have earned instead.
  • The change in quantity of goods sold upon changes in prices is defined as price elasticity. There are many factors which determine the elasticity of a good, a major factor being the number of substitutes/alternatives available in the market.
  • Apart from the apparently rational factors which seek to explain the buying behaviors, there are a slew of factors which influence the end consumers’ buying decisions which are rather abstract. Convenience, brand loyalty, EMI options and marketing initiatives can have a great influence on the buying behavior of consumers.

 

Microeconomics examples using a simple case study

Let us imagine a hypothetical company that manufactures footwear. The top executives of the firm will look at the overall trends in consumer choices to determine the direction which they should take. Marketing and advertising affects the consumer perception directly, and the “optimal” marketing spend takes into account the target audience of the good.

A multitude of factors will determine the number of units that they should produce this year and the price point at which they should sell. Interestingly, macroeconomic indicators will also influence their decision making – if there is an overall recession in the economy and the unemployment rate has increased then the number of shoes that they should manufacture should drop.

In the face of competition, many of the firms’ decisions will be reactive instead of being proactive. If the firm has positioned itself as a luxury footwear maker (Jimmy Choo?), then apart from just looking at the profit margins like every Joe Inc., they also have to factor in the brand equity while making any pricing decisions (perhaps Apple won’t start to sell iPhones at ~15k anytime soon in India – they won’t be “iPhones” anymore).
 

Conclusion

The conception of free markets and the availability of a wide array of choices for the consumers is one of the mainstays of capitalism. The competitors constantly realign themselves to meet the demands of market, and free will of the end consumer ensures that no supplier has undue leverage to influence overall prices.

The constant tug of war between the suppliers and consumers ensure that both entities have an equal and complementary role in determining the optimum price for any good.

Microeconomics is a bridge between the businesses and the end consumers – it connects the overall consumer sentiment related to utility, with the demand-supply driven dynamics of the suppliers.

Though many concepts touched by microeconomics are abstract, the lessons derived from microeconomics are tangible and can be converted into cold mathematical numbers with a reasonable accuracy. The aggregated numbers coming from the conceptual world of economics have the ability to drive decisions of large corporations, and we can truly afford to be spoilt for choices.
 

Other important topics in Economics

Introduction to Economics
Introduction to Macroeconomics
Game Theory in Economics
Price Elasticity of Demand

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