Microeconomics (from Greek prefix mikro- meaning "small") is a branch
of economics that studies the behavior of individuals and firms in
making decisions regarding the allocation of scarce resources and the
interactions among these individuals and firms.
One goal of microeconomics is to analyze the market mechanisms that
establish relative prices among goods and services and allocate
limited resources among alternative uses.
conditions under which free markets lead to desirable allocations. It
also analyzes market failure, where markets fail to produce efficient
Microeconomics stands in contrast to macroeconomics, which involves
"the sum total of economic activity, dealing with the issues of
growth, inflation, and unemployment and with national policies
relating to these issues".
Microeconomics also deals with the
effects of economic policies (such as changing taxation levels) on the
aforementioned aspects of the economy. Particularly in the wake of
the Lucas critique, much of modern macroeconomic theory has been built
upon microfoundations—i.e. based upon basic assumptions about
1 Assumptions and definitions
2 Basic microeconomic concepts
2.1 Demand, supply, and equilibrium
2.2 Measurement of elasticities
2.3 Consumer demand theory
2.4 Theory of production
2.5 Costs of production
2.6 Opportunity cost
2.7 Market structure
2.8 Perfect competition
2.9 Imperfect competition
2.9.1 Monopolistic competition
2.10 Game theory
2.11 Labor economics
Economics of information
6 Further reading
7 External links
Assumptions and definitions
Microeconomic theory typically begins with the study of a single
rational and utility maximizing individual. To economists, rationality
means an individual possesses stable preferences that are both
complete and transitive. The technical assumption that preference
relations are continuous is needed to ensure the existence of a
utility function. Although microeconomic theory can continue without
this assumption, it would make comparative statics impossible since
there is no guarantee that the resulting utility function would be
Microeconomic theory progresses by defining a competitive budget set
which is a subset of the consumption set. It is at this point that
economists make The technical assumption that preferences are locally
non-satiated. Without the assumption of LNS (local non-satiation)
there is no guarantee that a rational individual would maximize
utility. With the necessary tools and assumptions in place the utility
maximization problem (UMP) is developed.
The utility maximization problem is the heart of consumer theory. The
utility maximization problem attempts to explain the action axiom by
imposing rationality axioms on consumer preferences and then
mathematically modeling and analyzing the consequences. The utility
maximization problem serves not only as the mathematical foundation of
consumer theory but as a metaphysical explanation of it as well. That
is, the utility maximization problem is used by economists to not only
explain what or how individuals make choices but why individuals make
choices as well.
The utility maximization problem is a constrained optimization problem
in which an individual seeks to maximize utility subject to a budget
constraint. Economists use the extreme value theorem to guarantee that
a solution to the utility maximization problem exists. That is, since
the budget constraint is both bounded and closed, a solution to the
utility maximization problem exists. Economists call the solution to
the utility maximization problem a Walrasian demand function or
The utility maximization problem has so far been developed by taking
consumer tastes (i.e. consumer utility) as the primitive. However, an
alternative way to develop microeconomic theory is by taking consumer
choice as the primitive. This model of microeconomic theory is
referred to as revealed preference theory.
The supply and demand model describes how prices vary as a result of a
balance between product availability at each price (supply) and the
desires of those with purchasing power at each price (demand). The
graph depicts a right-shift in demand from D1 to D2 along with the
consequent increase in price and quantity required to reach a new
market-clearing equilibrium point on the supply curve (S).
The theory of supply and demand usually assumes that markets are
perfectly competitive. This implies that there are many buyers and
sellers in the market and none of them have the capacity to
significantly influence prices of goods and services. In many
real-life transactions, the assumption fails because some individual
buyers or sellers have the ability to influence prices. Quite often, a
sophisticated analysis is required to understand the demand-supply
equation of a good model. However, the theory works well in situations
meeting these assumptions.
Mainstream economics does not assume a priori that markets are
preferable to other forms of social organization. In fact, much
analysis is devoted to cases where market failures lead to resource
allocation that is suboptimal and creates deadweight loss. A classic
example of suboptimal resource allocation is that of a public good. In
such cases, economists may attempt to find policies that avoid waste,
either directly by government control, indirectly by regulation that
induces market participants to act in a manner consistent with optimal
welfare, or by creating "missing markets" to enable efficient trading
where none had previously existed.
This is studied in the field of collective action and public choice
theory. "Optimal welfare" usually takes on a Paretian norm, which is a
mathematical application of the Kaldor–Hicks method. This can
diverge from the Utilitarian goal of maximizing utility because it
does not consider the distribution of goods between people. Market
failure in positive economics (microeconomics) is limited in
implications without mixing the belief of the economist and their
The demand for various commodities by individuals is generally thought
of as the outcome of a utility-maximizing process, with each
individual trying to maximize their own utility under a budget
constraint and a given consumption set.
Basic microeconomic concepts
The study of microeconomics involves several "key" areas:
Demand, supply, and equilibrium
Main article: Supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a
perfectly competitive market. It concludes that in a perfectly
competitive market with no externalities, per unit taxes, or price
controls, the unit price for a particular good is the price at which
the quantity demanded by consumers equals the quantity supplied by
producers. This price results in a stable economic equilibrium.
Measurement of elasticities
Main article: Elasticity (economics)
Elasticity is the measurement of how responsive an economic variable
is to a change in another variable. Elasticity can be quantified as
the ratio of the percentage change in one variable to the percentage
change in another variable, when the later variable has a causal
influence on the former. It is a tool for measuring the responsiveness
of a variable, or of the function that determines it, to changes in
causative variables in unitless ways. Frequently used elasticities
include price elasticity of demand, price elasticity of supply, income
elasticity of demand, elasticity of substitution or constant
elasticity of substitution between factors of production and
elasticity of intertemporal substitution.
Consumer demand theory
Main article: Consumer choice
Consumer demand theory relates preferences for the consumption of both
goods and services to the consumption expenditures; ultimately, this
relationship between preferences and consumption expenditures is used
to relate preferences to consumer demand curves. The link between
personal preferences, consumption and the demand curve is one of the
most closely studied relations in economics. It is a way of analyzing
how consumers may achieve equilibrium between preferences and
expenditures by maximizing utility subject to consumer budget
Theory of production
Main article: Production theory
Production theory is the study of production, or the economic process
of converting inputs into outputs. Production uses resources to create
a good or service that is suitable for use, gift-giving in a gift
economy, or exchange in a market economy. This can include
manufacturing, storing, shipping, and packaging. Some economists
define production broadly as all economic activity other than
consumption. They see every commercial activity other than the final
purchase as some form of production.
Costs of production
Main article: Cost-of-production theory of value
The cost-of-production theory of value states that the price of an
object or condition is determined by the sum of the cost of the
resources that went into making it. The cost can comprise any of the
factors of production: labour, capital, land.
Technology can be viewed
either as a form of fixed capital (e.g. plant) or circulating capital
(e.g. intermediate goods).
Main article: Opportunity cost
The economic idea of opportunity cost is closely related to the idea
of time constraints. You can do only one thing at a time, which means
that, inevitably, you’re always giving up other things.
The opportunity cost of any activity is the value of the next-best
alternative thing you may have done instead.
Opportunity cost depends
only on the value of the next-best alternative. It doesn’t matter
whether you have 5 alternatives or 5,000.
Opportunity costs can tell you when not to do something as well as
when to do something. For example, you may like waffles, but you like
chocolate even more. If someone offers you only waffles, you’re
going to take it. But if you’re offered waffles or chocolate,
you’re going to take the chocolate. The opportunity cost of eating
waffles is sacrificing the chance to eat chocolate. Because the cost
of not eating the chocolate is higher than the benefits of eating the
waffles, it makes no sense to choose waffles. Of course, if you choose
chocolate, you’re still faced with the opportunity cost of giving up
having waffles. But you’re willing to do that because the waffle's
opportunity cost is lower than the benefits of the chocolate.
Opportunity costs are unavoidable constraints on behaviour because you
have to decide what’s best and give up the next-best alternative.
Main article: Market structure
The market structure can have several types of interacting market
systems. Different forms of markets are a feature of capitalism, and
advocates of socialism often criticize markets and aim to substitute
markets with economic planning to varying degrees. Competition is the
regulatory mechanism of the market system.
Some examples of markets:
media exchange markets
Main article: Perfect competition
Perfect competition is a situation in which numerous small firms
producing identical products compete against each other in a given
Perfect competition leads to firms producing the socially
optimal output level at the minimum possible cost per unit. Firms in
perfect competition are "price takers" (they do not have enough market
power to profitably increase the price of their goods or services). A
good example would be that of digital marketplaces, such as eBay, on
which many different sellers sell similar products to many different
Main article: Imperfect competition
In economic theory, imperfect competition is a type of market
structure showing some but not all features of competitive markets.
Main article: Monopolistic competition
Monopolistic competition is a situation in which many firms with
slightly different products compete. Production costs are above what
may be achieved by perfectly competitive firms, but society benefits
from the product differentiation. Examples of industries with market
structures similar to monopolistic competition include restaurants,
cereal, clothing, shoes, and service industries in large cities.
Main article: monopoly
A monopoly (from Greek monos μόνος (alone or single) + polein
πωλεῖν (to sell)) is a market structure in which a market or
industry is dominated by a single supplier of a particular good or
service. Because monopolies have no competition they tend to sell
goods and services at a higher price and produce below the socially
optimal output level. Although not all monopolies are a bad thing,
especially in industries where multiple firms would result in more
problems than benefits (i.e. natural monopolies).
Natural monopoly: A monopoly in an industry where one producer can
produce output at a lower cost than many small producers.
Main article: Oligopoly
An oligopoly is a market structure in which a market or industry is
dominated by a small number of firms (oligopolists). Oligopolies can
create the incentive for firms to engage in collusion and form cartels
that reduce competition leading to higher prices for consumers and
less overall market output. Alternatively, oligopolies can be
fiercely competitive and engage in flamboyant advertising
Duopoly: A special case of an oligopoly, with only two firms. Game
theory can elucidate behavior in duopolies and oligopolies.
Main article: Monopsony
A monopsony is a market where there is only one buyer and many
Main article: Oligopsony
An oligopsony is a market where there are a few buyers and many
Main article: Game theory
Game theory is a major method used in mathematical economics and
business for modeling competing behaviors of interacting agents. The
term "game" here implies the study of any strategic interaction
between people. Applications include a wide array of economic
phenomena and approaches, such as auctions, bargaining, mergers &
acquisitions pricing, fair division, duopolies, oligopolies, social
network formation, agent-based computational economics, general
equilibrium, mechanism design, and voting systems, and across such
broad areas as experimental economics, behavioral economics,
information economics, industrial organization, and political economy.
Main article: Labor economics
Labor economics seeks to understand the functioning and dynamics of
the markets for wage labor. Labor markets function through the
interaction of workers and employers.
Labor economics looks at the
suppliers of labor services (workers), the demands of labor services
(employers), and attempts to understand the resulting pattern of
wages, employment, and income. In economics, labor is a measure of the
work done by human beings. It is conventionally contrasted with such
other factors of production as land and capital. There are theories
which have developed a concept called human capital (referring to the
skills that workers possess, not necessarily their actual work),
although there are also counter posing macro-economic system theories
that think human capital is a contradiction in terms.
Welfare economics is a branch of economics that uses microeconomics
techniques to evaluate well-being from allocation of productive
factors as to desirability and economic efficiency within an economy,
often relative to competitive general equilibrium. It analyzes
social welfare, however measured, in terms of economic activities of
the individuals that compose the theoretical society considered.
Accordingly, individuals, with associated economic activities, are the
basic units for aggregating to social welfare, whether of a group, a
community, or a society, and there is no "social welfare" apart from
the "welfare" associated with its individual units.
Economics of information
Main article: Information economics
Information economics or the economics of information is a branch of
microeconomic theory that studies how information and information
systems affect an economy and economic decisions. Information has
special characteristics. It is easy to create but hard to trust. It is
easy to spread but hard to control. It influences many decisions.
These special characteristics (as compared with other types of goods)
complicate many standard economic theories.
United States Capitol Building: meeting place of the United States
Congress, where many tax laws are passed, which directly impact
economic welfare. This is studied in the subject of public economics.
Applied microeconomics includes a range of specialized areas of study,
many of which draw on methods from other fields. Industrial
organization examines topics such as the entry and exit of firms,
innovation, and the role of trademarks.
Labor economics examines
wages, employment, and labor market dynamics. Financial economics
examines topics such as the structure of optimal portfolios, the rate
of return to capital, econometric analysis of security returns, and
corporate financial behavior.
Public economics examines the design of
government tax and expenditure policies and economic effects of these
policies (e.g., social insurance programs).
Political economy examines
the role of political institutions in determining policy outcomes.
Health economics examines the organization of health care systems,
including the role of the health care workforce and health insurance
Education economics examines the organization of education
provision and its implication for efficiency and equity, including the
effects of education on productivity. Urban economics, which examines
the challenges faced by cities, such as sprawl, air and water
pollution, traffic congestion, and poverty, draws on the fields of
urban geography and sociology.
Law and economics
Law and economics applies microeconomic
principles to the selection and enforcement of competing legal regimes
and their relative efficiencies.
Economic history examines the
evolution of the economy and economic institutions, using methods and
techniques from the fields of economics, history, geography,
sociology, psychology, and political science.
History of microeconomics
The difference between microeconomics and macroeconomics was
introduced in 1933 by the Norwegian economist
Ragnar Frisch (Nobel
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