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 wellbeing. Although it may seem to be about money-related matters, its scope is in fact much wider. It is about how all sorts of 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.
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.
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 substition 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.
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.
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.
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  but that has been contested by economists of the Austrian School .
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.
- Milton Friedman Essays in Positive Economics pages 18 to 39 Phoenix Books 1966
- Stephen Littlechild The Fallacy of the Mixed Economy Hobart Paper No 80 Institute of Economic Affairs 1986