Chapter 1
In This Chapter
Introducing the areas that are the focus of microeconomics
Understanding the key roles of rational decision-making, competition, and cooperation
Seeing that markets don’t always work
As we’re sure you know, micro as a prefix often indicates something very small, such as a microchip or a microcosm. Micro can also mean something that isn’t small itself but that is used to examine small things, such as a microscope.
Microeconomics is the area of economics that studies the decisions of individual consumers and producers and how they come together to make markets. It explores how people decide to do what they do and what happens when interests conflict. It also considers how people can improve markets through their actions, the effects of laws, and other outside interventions. So despite the name, microeconomics is in fact a huge subject.
Traditionally, people contrasted microeconomics with macroeconomics — the study of national economies and weighty topics such as growth, unemployment, inflation, national debt, and investments. But over the years, the scope of microeconomics has grown; today economists analyze topics in macroeconomics using microeconomic tools.
In general, microeconomics works by building models of these situations. Models are mathematical — or graphical — pictures of how the world works given some basic assumptions. Models aren’t reality; they’re a description of something that resembles reality. Like an architect’s model of a house, models don’t have to stand up to reality; they just have to provide a feeling for what the real world looks like. Microeconomists also test models against real data to see how well the models work — the answer is often variably.
This chapter introduces you to microeconomics and its core areas of interest, and we touch on the fact that markets don’t always work.
Microeconomics is fundamentally about what happens when individuals and companies make decisions. The idea is to understand how those decisions are made and explore their consequences.
What happens, for example, when prices of houses go up? Well, on the one hand, people are likely to buy fewer or smaller houses. On the other hand, developers may want to build more houses so that they can get more revenue. The result could be a lot of unsold houses! Then there will be pressure to get rid of those stocks of unsold houses, and that leads to lower prices.
The way markets work seems so impersonal because every one of the smallest units — small companies and individuals — makes up just a tiny fraction of all the decisions taken. Even the biggest corporations or most powerful governments have limitations on their ability to influence the world. Microeconomics also looks at the exception to the rule when a decision-maker — a buyer or seller — is not so small and can influence market forces.
This is one reason why economists center their models on choice. After all, when you don’t have options to choose from, you can’t make a decision. Deciding to make something or to buy something is the starting point for microeconomics.
To a microeconomist, decisions aren’t right or wrong. Instead, they’re one of the following:
Optimal: Getting the best of what you want, given what’s available.
Of course, a model of decisions needs two sides:
This book presents a few ways that microeconomists look at these decisions. Chapters 2–8 use a framework for making the best decision given some kind of constraint — budget, time, or whatever else constrains you — to show you how microeconomists look at individuals and companies separately. In Chapters 9–15, the famous supply and demand model shows you how different types of markets lead to different results. And Chapters 16–19 introduce you to game theory, which looks at how individuals or companies (or even other entities, such as governments) strategically interact with each other.
Economists look at decisions in a slightly different way from how you might expect. They don’t have a model of all the things that you as a consumer would use to inform your decisions. They don’t know, for example, who you are, or more precisely what all your values are. They make no assumptions about gender, ethnicity, sexuality, or anything else. They just know that you need to make choices and they explore how you may do so.
To begin with, these models are quite simple. If Bob has $10 in his pocket and he wants to decide between having a burrito or a pizza, he’ll get the meal that gives him the most value or utility, given that it costs less than $10. Simple!
But later on, the models start to incorporate all kinds of other factors, such as budget constraints (discussed in Chapter 5): If Bob’s income goes up, will he buy more or less pizza? Or what about the utility of other people? If Bob’s friends won’t eat pizza with him (perhaps he chews with his mouth open), he may get less utility from the pizza. Eventually, even with simple assumptions, models can end up incorporating some pretty complicated reasoning.
When you look at this example from the perspective of the pizza restaurant, things also start off simple: The restaurant just wants to make as much profit as possible, working to reduce its costs to do so. But what if you factor in competitors? What if the shareholders of the pizza company — the company has grown, adding layer on tasty layer — have different interests than the managers? What if the managers don’t just want to get costs down, but want to keep competitors out? Again, the key is to start from the fewest justifiable assumptions and then build up as you get more familiar with models.
Markets are places, real or virtual, where consumers and producers come together to trade. In theory, the trades make both sides better off, though not necessarily to the same extent.
Microeconomists say that markets are equilibrium-seeking, which means that trading in a market ultimately leads to a point where as much is supplied as consumers demand (and no more or less). The concept of equilibrium is much used in microeconomics, especially in the supply and demand model that we introduce in Chapter 9. This model looks at partial equilibrium or an equilibrium in one given market (for example, the market for canned tuna, or the market for books). We also want to understand how a partial equilibrium is related to the following:
Of course, reality can get very complicated, and there are situations where someone — often government, but sometimes private monopolists or property owners — wants to control the price, which is often not desirable. Take rent control, for example. Introduce too low a maximum rent, and more people will want to rent than there are people who are willing to put their house up for rent. As a result, setting a rent control at a very low level just creates homelessness — more people trying to rent, but landlords withdrawing their properties from the market because the price is too low for them to bother.
What if you set the rents too high? Well, if the maximum rent is above the equilibrium in the market, landlords are more willing to rent at that price and so more enter the market. But fewer renters are willing to rent at that price, so the result is an excess supply of rentable properties. As a result, some landlords drop out — those that need the highest level of rent to make a profit — and the price falls until it reaches market equilibrium.
Markets are themselves complex things in reality and vary widely from type to type. For example, financial markets are different from labor markets in their scope, participants, and trading outcomes. Microeconomists look at all these types of markets, starting with the simplest model, and then try to incorporate distinctive differences in these markets into the models.
The situation of many companies following their own interests leads to competition (we discuss perfect competition, which consumers usually love, in Chapter 10, and imperfect competition in Chapter 11). In almost all circumstances, competition is a pretty good thing, because it can lead to lower costs or more innovation. For example, if only one store operates in your area, it may be able to get away with selling milk for $5 a gallon. But if other stores get in on the act, the competition leads to the price falling and stores trying to keep their costs low.
Microeconomists are often accused of overselling the benefits of competition, but they also point out that cooperation can be perilous too. When a group of companies with large shares of a relevant market work together, the result is often harmful to the public, as Adam Smith pointed out. Working together in that way is illegal, not surprisingly. Similarly, a trade union where a lot of people work together to get the best bargain with their industry can have negative effects on anyone not a member of that union. Microeconomists go on to investigate all these possibilities.
At some point, no matter where they operate in the world, businesses have to deal with the legal institutions that govern the region where they operate. In general, a lot of basic rules restricting how business is conducted underpin every legal market, from ensuring that products are what businesses say they are to not allowing companies to exploit market dominance. But if a basic tenet of microeconomics is that trades and markets emerge with no one in charge, why do we need such governance?
Because markets in reality are far from perfect. Sometimes market trades impose costs, such as environmental costs, upon people who aren’t involved in that particular market. Sometimes restricting trade or conduct in a given market leads to better behavior. But perhaps the most interesting reason for regulation is because of what happens when a competitor gets too successful. When that happens, the company makes larger profits, which is good for shareholders. But suppose market conditions are such that no company can set up as a rival — maybe the costs involved in being in that market are too high, or the successful competitor holds the entire supply of a key resource.
The idea is that competition is good, so stopping the biggest companies from subverting competition requires constant vigilance. In practice, it means that part of the legal system switches from treating everyone equally to treating those companies with the biggest market shares differently from smaller ones.
In all these cases, companies are treated differently because everyone recognizes that if competition fails, everyone loses out in the long run — ultimately getting poorer quality goods at higher prices.
If you look around the world, you find almost no examples of countries where absolutely everything gets produced through markets alone. Almost everywhere, markets co-exist with other systems: the government, philanthropy, sometimes even the “command and control”: structure of a military.
Economists tend to take a practical attitude to markets, perhaps more so than the general public suspects. Economists certainly don’t assume that markets can inevitably produce everything that everyone wants with no drawbacks. They believe that in some cases market-based prices would help improve decision-making, and that choice is valuable in and of itself. But that doesn’t mean economists want to introduce markets in absolutely everything.