6 Things That Encapsulates Microeconomics6 min read

Ever wondered why supermarkets not only stock up on groceries and household items but also sell contact lenses and plasma TVs these days? Can you explain why local petrol stations lowered prices twice in a day? Do you know the rationale behind charging different transport fares for different groups of consumers? (i.e. student pricing and senior citizen pricing)

If you are keen to find out the answers to the questions above, you are in for an adventure. As you find out more about Microeconomics, the reasons driving the behaviour of the above-mentioned firms will jump out at you. I shall begin this series with a list of 6 things that to me encapsulates microeconomics (at least at the H2 syllabus level).

1. It is about the study of markets and market agents.

Microeconomics is about individuals making decisions that impacts the outcomes in different markets. Equilibrium price and equilibrium quantity are two of the many things that economists are interested to find out with regard to the outcomes of markets.

There are three types of markets in the economy, the goods and services market, where most of the transactions in the economy take place, the labour market, which matches workers to employers and lastly the financial market, where loans take place and redistribution of risk happens.

The three types of markets are in general characterised by similar principles, but each is inflicted with its own set of problems and issues. In the H2 syllabus, the focus is on the goods and services market.

2. People are rational.

This is an important underlying assumption in microeconomics. Most of economic theory is based on the idea that we humans are self maximising individuals, who tend to make decisions at the margin. As someone new to economics, this may seem puzzling to you. To see a comic representation of this, check out 2:39 of

[youtube=http://www.youtube.com/watch?v=VVp8UGjECt4]

Basically, what this means is that before an economic agent takes action, he considers if the marginal benefit of what he is about to do exceeds the marginal cost of doing it. In other words, the additional benefit from doing more of a particular activity must exceed the marginal cost of doing it before the choice is made to do something.

This assumption is important for many of the theories in microeconomics to work, because thinking at the margin leads to optimal decisions being taken, albeit subject to preference, resources and informational constraints. Whether or not it is a reasonable assumption to make is another topic for discussion in itself.

3. The indispensable role of the price mechanism.

The most impressive function of the price mechanism is its ability to carry and transmit information. Every pricetag in the economy tells a story, of the value society places on the factors of production used to create the particular good or service. This particular price level signals to consumers how much of the good or service to consume and to producers how much of the good or service to produce. When prices are off from the equilibrium price, there will be a mismatch of demand and supply. The resulting surplus or shortage will induce market participants to act in a way that will restore prices to its equilibrium level where demand equals supply.

In the long-run the price mechanism acts as a negative feedback mechanism. For example, when prices increase due to growing scarcity of factors of production, consumers will be induced to consume less of the good by changing their consumption habits and switching to alternatives. The fall in demand will tend to push prices down. Similarly, if prices increase due to growing demand from an increasing population, producers will be induced to produce more of the good, and there will also be more entrants into the market; there is likely to be a downward movement in prices due to the increase in supply.

It follows that prices must be relatively stable in most markets. However, this price stability of markets is often not observed in real life for a variety of reasons.

4. The outcomes of markets.

The study of microeconomics often involves examining certain market outcomes. Besides knowing the equilibrium price and quantity of different markets, economists would also like to find out if markets are efficient. Questions such as ‘what to produce’, ‘how to produce’, ‘how much to produce’ are crucial to the notion of economic efficiency. The idea that the market, which consists of self-maximising individuals, can achieve efficient outcomes for society is a novel one ever since Adam Smith proposed it in his Wealth of Nations.

In order to study markets more effectively, economists have come up with different market structures which model firms’ behaviour depending on the characteristics of the market. On one end of the spectrum, there is the perfectly competitive market which most of the neo-classical microeconomics theory is based on and on the other end of the spectrum there is the monopoly who is able to set prices in a market. The outcomes in these different market varies, but to facilitate comparison, we often look at the following ideas at the H2 level:

  • Allocative Efficiency
  • Productive Efficiency
  • Equity
  • Choice
  • Innovation

5. The market can fail.

The market is often not perfect. It is plauged with problems such as imperfect information, imperfect competition, externalities and the failure for some goods to be produced by the free market. The presence of such problems mean that the free market can hardly ever result in an efficient outcome. Consumers with imperfect information cannot discern what is best for them; firms with market power often exploit consumers by charging higher prices; pollution becomes a severe problem because common spaces such as the environment and our atmosphere does not have clear ownership rights and are often neglected. The price mechanism ends up conveying the wrong information in many of these cases.

6. It can be prescriptive.

If the price mechanism is unable to convey the correct information to consumers and producers, should the government step in and displace the role of the price mechanism? If the free market cannot do the job on its own, should the government intervene? These are questions that are often examined in the study of microeconomics. There are frequently many policy options available to governments seeking to achieve more efficient outcomes in the markets. The question then becomes which of
these policies are the most desirable and whether the government can administer them effectively. Microeconomics becomes prescriptive in the sense that it can offer viable alternatives to the price mechanism which can be considered during the decision making process.

In the next couple of weeks, I will be expanding on many of these ideas in my posts. The challenge that I have posed to myself is to use as many different formats as possible in my posts. Readers, if you are keen to submit any post, or help me along in this endeavour, please feel free to contact me using the form below! [contact-form-7 404 "Not Found"]

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