ECONOMIC SERIES 7:6

What kinds of topics does microeconomics cover?

Microeconomics is the study of human action and interaction. The most common uses of microeconomics deal with individuals and firms that trade with one another, but its methods and insights can be applied to nearly every aspect of purposeful activity. Ultimately, microeconomics is about human choices and incentives.

Most people are introduced to microeconomics through the study of scarce resources, money prices, and the supply and demand of goods and services. For example, microeconomics is used to explain why the price of a good tends to rise as its supply falls, all other things being equal. These insights have obvious implications for consumers, producers, firms and governments.

Many academic settings treat microeconomics in a narrow, model-based and quantitative manner. Traditional supply and demand curves graph the quantity of a good in the market against its price. These models attempt to isolate individual variables and determine causal relationships or at least strong correlative relationships. Economists disagree about the efficacy of these models, but they are widely used as good heuristic devices.

The basic assumptions of microeconomics as a science, however, are neither model-based nor quantitative. Rather, microeconomics argues that human actors are rational and that they use scarce resources to accomplish purposeful ends. The dynamic interaction between scarcity and choice helps economists discover what humans consider valuable. Exchange, demand, prices, profits, losses and competition arise when humans voluntarily associate with each other to achieve their separate ends. In this sense, microeconomics is best thought of as a branch of deductive logic; models and curves are simply manifestations of these deductive insights.

Microeconomics is often contrasted with macroeconomics. In this context, microeconomics focuses on individual actors, small economic units and direct consequences of rational human choice. Macroeconomics tends to study large economic units and the indirect effects of interest rates, employment, government influence and money inflation.

How does government policy impact microeconomics?

A government policy has microeconomic effects whenever its implementation alters the inputs and incentives for individual economic decisions. These changes come in many forms, including tax policy, fiscal policy, regulations, tariffs, subsidies, legal tender laws, licensing and public-private partnerships (to name a few). These policies manipulate the costs and benefits that individual actors face in nearly every facet of modern life.

Intentional and Unintentional Consequences

Sometimes the impacts of government policy are intentional. The government might provide a subsidy to farmers to make their businesses more profitable and encourage farm production. Conversely, the government might put a tax on cigarettes and alcohol to discourage behavior that it doesn’t approve of. Other impacts are unintentional.

When the U.S. government propped up wages during the Great Depression, for example, it unintentionally made it unprofitable for individual firms to hire extra employees.

The nature of these causes can be understood by identifying the forces behind microeconomic decisions.

Important Concepts in Microeconomics

The models in microeconomics study the interaction of supply and demand within individual markets and specific actors. If a government policy mandates an artificially high minimum wage and subsequently leads to greater unemployment, microeconomics describes how the floor on labor costs changes inputs for firms. It is not concerned with measuring the aggregate level of unemployment in the entire economy.

Macroeconomics operates with key assumptions based on observable human behavior. It assumes that individual actors are utility maximizing and that they make rational decisions based on known information. In addition, it assumes that resources are scarce and, therefore, can be assigned monetary value and that present consumption is preferred to future consumption.

Macroeconomic actors have to adjust their behavior whenever government changes the information available, changes the monetary value assigned to scarce resources or places restrictions on the kinds of decisions that individuals can make.

How Government Policy Changes Microeconomic Factors

Even the existence of a non-voluntary government has microeconomic impacts. Governments are financed through taxes, which must be taken from private actors. When this happens, individuals and businesses must either spend less income or work and produce an additional amount to offset the impact of the taxes.

Governments can also alter markets when they decide to spend money. Any individuals or businesses that receive government funds receive, in effect, a wealth transfer from every other taxpayer. If a business receives a subsidy from the government, it produces at a higher cost curve than is possible without the subsidy. All other actors that might have received those funds (were it not for the taxation and subsidy) have correspondingly less income or revenue.

Fiscal policy directly impacts prices. When the government spends $1 million purchasing computers, it bids up the price of computers in the short run. This crowds out other individuals who are subsequently priced out of the market. The same effect occurs when the government issues bonds and crowds out other lenders. This crowding out becomes even more disruptive when the government directly provides services and employs workers.

In Conclusion

Governments either change the quantity of a good available (supply) or the amount of funds that can be directed toward those goods (demand). Governments can also make some forms of trade illegal or make them illegal under certain contexts. All of these impact the choices that microeconomic actors face and change their decision-making processes.

How does economics study human action and behavior?

In many respects, economics is more similar to social sciences such as psychology and sociology than physical sciences such as chemistry and biology. Economics (particularly microeconomics) is ultimately concerned with why, when and how human beings trade with each other. Different schools of thought have taken the field toward increasing levels of mathematical sophistication and model-based regression forecasting, but the building blocks continue to be human actors and their behaviors.

Consider the laws of supply and demand in economics. When placed on a microeconomic chart, it looks as though price is determined through a mechanical adjustment based on the quantity of a product and the number of buyers in the market. In reality, a price is the agreed-upon level at which a seller is willing to part with a good and the buyer is willing to assume it. Consumers have to compete with other consumers when bidding for a good. Producers have to compete with other producers for those consumers. It’s the actions of individual actors that determine economic reality – not the other way around.

The field of economics attempts to understand the patterns of individual decisions within the context of a world that has scarce resources.

Human Action and Determining Value

Economic actors will regularly engage in transactions that they anticipate will make them better off. If a consumer buys a loaf of bread for three dollars, he/she is implicitly stating that they value the bread more than three dollars. The seller, by offering the loaf for three dollars, is implicitly stating that the three dollars are more valuable than the bread.

Presumably, the general market for bread in the area suggests that three dollars is an acceptable price to entice businesses to become bread retailers and assume the associated risks. This also means that wheat farmers are sufficiently compensated, transportation is economically feasible and hundreds (if not thousands) of other human actions can be coordinated in a sustaining way.

Each actor in the chain of financing, production and consumption is receiving enough value to entice their cooperation. To save time, economics studies the price rather than breaking down every single trade, transaction and motivation. The root is a huge series of human value judgments and behaviors. The price, in a sense, economizes on the information.

Analyzing and Understanding Human Behavior

Economics appears to be superficially concerned with abstractions such as demand curves, production possibilities frontiers or interest rates. None of those inputs actually exist in a tangible sense. However, the root is always individual human action. Every actor is simultaneously coordinating his activities in a meaningful, value-driven way. Those values and actions are dynamically captured through broad economic indicators and subsequently analyzed.

Human action cannot be predicted with any certainty. No economist knows how much any single consumer will be willing to pay for a 50-inch television in 2024, for example. A basic understanding of human action can help economists identify meaningful tendencies in resource allocation, however.

What math skills do I need to study microeconomics?

Microeconomics can be, but is not necessarily, math-intensive. Fundamental microeconomic assumptions about scarcity, human choice, rationality, ordinal preferences or exchange do not require any advanced mathematical skills. On the other hand, many academic courses in microeconomics use mathematics to inform about social behavior in a quantitative way. Common mathematical techniques in microeconomics courses include geometry, order of operations, balancing equations and using derivatives for comparative statistics.

Logical Deduction in Economics

Economics, like many aspects of geometry, is not readily verifiable or falsifiable by use of empirical quantitative analysis. Rather, it flows from logical proofs. For example, economics assumes that people are purposeful actors (meaning that actions are not random or accidental) and that they must interact with scarce resources in order to achieve conscious ends.

These principles are immutable and not testable, as are the deductions which flow from them. Like the Pythagorean theorem, each step of the proof is necessarily true as long as the prior steps did not contain any logical error.

Mathematics in Microeconomics

Human action does not adhere to constant mathematical formulas. Microeconomics might appropriately use mathematics to highlight existing phenomena or draw graphs to visually show the implications of human action.

Students of microeconomics should familiarize themselves with optimization techniques using derivatives. They should understand how slope and fractional exponents interact within linear and exponential equations. For example, students should be able to derive the value of the slope of a line using the linear equation “y = a + bx” and solving for b.

Supply and demand curves intersect to show equilibrium. Economists use endogenous variables to summarize the forces that impact supply and demand themselves. In specific markets, these variables can be isolated to show how supply or demand directly relate to price or quantity. These equations become increasingly dynamic and complicated in advanced microeconomics.

It is a common fallacy to interpret mathematical causality with real economic causality. Price does not cause supply or demand any more than slope causes profits. Rather, human action drives all of these variables simultaneously in a way that mathematics cannot completely capture.

5 Nobel Prize-Winning Economic Theories You Should Know About

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has been awarded 44 times to 71 Laureates who have researched and tested dozens of ground-breaking ideas. Here are five prize-winning economic theories that you’ll want to be familiar with. These are ideas you’re likely to hear about in news stories because they apply to major aspects of our everyday lives.

1. Management of Common Pool Resources 
In 2009, Indiana University political science professor Elinor Ostrom became the first woman to win the prize. She received it “for her analysis of economic governance, especially the commons.” Ostrom’s research showed how groups work together to manage common resources such as water supplies, fish and lobster stocks, and pastures through collective property rights. She showed that ecologist Garrett Hardin’s prevailing theory of the “tragedy of the commons” is not the only possible outcome, or even the most likely outcome, when people share a common resource.

Hardin’s theory says that common resources should be owned by the government or divided into privately owned lots to prevent the resources from becoming depleted through overuse. He said that each individual user will try to obtain maximum personal benefit from the resource to the detriment of later users. Ostrom showed that common pool resources can be effectively managed collectively, without government or private control, as long as those using the resource are physically close to it and have a relationship with each other. Because outsiders and government agencies don’t understand local conditions or norms, and lack relationships with the community, they may manage common resources poorly. By contrast, insiders who are given a say in resource management will self-police to ensure that all participants follow the community’s rules.

Learn more about Ostom’s prize-winning research in her 1990 book, “Governing the Commons: The Evolution of Institutions for Collective Action,” and in her 1999 Science journal article, “Revisiting the Commons: Local Lessons, Global Challenges.”

2. Behavioral Economics 
The 2002 prize went to psychologist Daniel Kahneman, “for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty.” Kahneman showed that people do not always act out of rational self-interest, as the economic theory of expected utility maximization would predict. This concept is crucial to the field of study known as behavioral finance. Kahneman conducted his research with Amos Tversky, but Tversky was not eligible to receive the prize because he died in 1996 and the prize is not awarded posthumously.

Kahneman and Tversky identified common cognitive biases that cause people to use faulty reasoning to make irrational decisions. These biases include the anchoring effect, the planning fallacy and the illusion of control. Their article, “Prospect Theory: An Analysis of Decision Under Risk,” is one of the most frequently cited in economics journals. Their award-winning prospect theoryshows how people really make decisions in uncertain situations. We tend to use irrational guidelines such as perceived fairness and loss aversion, which are based on emotions, attitudes and memories, not logic. For example, Kahneman and Tversky observed that we will expend more effort to save a few dollars on a small purchase than to save the same amount on a large purchase.

Kahneman and Tversky also showed that people tend to use general rules, such as representativeness, to make judgments that contradict the laws of probability. For example, when given a description of a woman who is concerned about discrimination and asked if she is more likely to be a bank teller or a bank teller who is a feminist activist, people tend to assume she is the latter even though probability laws tell us she is much more likely to be the former.

3. Asymmetric Information 
In 2001, George A. Akerlof, A. Michael Spence and Joseph E. Stiglitz won the prize “for their analyses of markets with asymmetric information.” The trio showed that economic models predicated on perfect information are often misguided because, in reality, one party to a transaction often has superior information, a phenomenon known as “information asymmetry.”

An understanding of information asymmetry has improved our understanding of how various types of markets really work and the importance of corporate transparency. Akerlof showed how information asymmetries in the used car market, where sellers know more than buyers about the quality of their vehicles, can create a market with numerous lemons (a concept known as “adverse selection“). A key publication related to this prize is Akerlof’s 1970 journal article, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.”

Spence’s research focused on signaling, or how better-informed market participants can transmit information to lesser-informed participants. For example, he showed how job applicants can use educational attainment as a signal to prospective employers about their likely productivity and how corporations can signal their profitability to investors by issuing dividends.

Stiglitz showed how insurance companies can learn which customers present a greater risk of incurring high expenses (a process he called “screening”) by offering different combinations of deductibles and premiums.

Today, these concepts are so widespread that we take them for granted, but when they were first developed, they were groundbreaking.

4. Game Theory
The academy awarded the 1994 prize to John C. Harsanyi, John F. Nash Jr. and Reinhard Selten “for their pioneering analysis of equilibria in the theory of non-cooperative games.” The theory of non-cooperative games is a branch of the analysis of strategic interaction commonly known as “game theory.” Non-cooperative games are those in which participants make non-binding agreements. Each participant bases his or her decisions on how he or she expects other participants to behave, without knowing how they will actually behave.

One of Nash’s major contributions was the Nash Equilibrium, a method for predicting the outcome of non-cooperative games based on equilibrium. Nash’s 1950 doctoral dissertation, “Non-Cooperative Games,” details his theory. The Nash Equilibrium expanded upon earlier research on two-player, zero-sum games. Selten applied Nash’s findings to dynamic strategic interactions, and Harsanyi applied them to scenarios with incomplete information to help develop the field of information economics. Their contributions are widely used in economics, such as in the analysis of oligopoly and the theory of industrial organization, and have inspired new fields of research.

5. Public Choice Theory
James M. Buchanan Jr. received the prize in 1986 “for his development of the contractual and constitutional bases for the theory of economic and political decision-making.” Buchanan’s major contributions to public choice theory bring together insights from political science and economics to explain how public-sector actors (e.g., politicians and bureaucrats) make decisions. He showed that, contrary to the conventional wisdom that public-sector actors act in the public’s best interest (as “public servants”), politicians and bureaucrats tend to act in their own self-interest, just like private-sector actors (e.g., consumers and entrepreneurs). He described his theory as “politics without romance.”

Using Buchanan’s insights regarding the political process, human nature and free markets, we can better understand the incentives that motivate political actors and better predict the results of political decision-making. We can then design fixed rules that are more likely to lead to desirable outcomes. For example, instead of allowing deficit spending, which political leaders are motivated to engage in because each program the government funds earns politicians support from a group of voters, we can impose a constitutional restraint on government spending, which benefits the general public by limiting the tax burden.

Buchanan lays out his award-winning theory in a book he coauthored with Gordon Tullock in 1962, “The Calculus of Consent: Logical Foundations of Constitutional Democracy.”

Honorable Mention: Black-Scholes Theorem
Robert Merton and Myron Scholes won the 1997 Nobel Prize in economics for the Black-Scholes theorem, a key concept in modern financial theory that is commonly used for valuing European options and employee stock options. Though the formula is complicated, investors can use an online options calculator to get its results by inputting an option’s strike price, the underlying stock’s price, the option’s time to expiration, its volatility and the market’s risk-free interest rate. Fisher Black also contributed to the theorem, but could not receive the prize because he passed away in 1995.

The Bottom Line
Each of the dozens of winners of the Nobel memorial prize in economics has made outstanding contributions to the field, and the other award-winning theories are worth getting to know, too. A working knowledge of the theories described here, however, will help you to establish yourself as someone who is in touch with the economic concepts that are essential to our lives today.

ECONOMIC SERIES 7:6