Microeconomics studies the economic actions and behaviour of individual units and small groups of individual units.
In microeconomic theory we discuss how the various cells of economic organism, that is, the various units of the economy such as thousands of consumers, thousands of producers or firms, thousands of workers and resource suppliers in the economy do their economic activities and reach their equilibrium states.
“Microeconomics consists of looking at the economy through a microscope, as it were, to see how the millions of cells in the body economic-the individuals or households as consumers, and the individuals or firms as producers—play their part in the working of the whole economic organism.”- Professor Lerner.
In other words, in microeconomics we make a microscopic study of the economy. But it should be remembered that microeconomics does not study the economy in its totality. Instead, in microeconomics we discuss equilibrium of innumerable units of the economy piecemeal and their inter-relationship to each other.
For instance, in microeconomic analysis we study the demand of an individual consumer for a good and from there go on to derive the market demand for the good (that is, demand of a group of individuals consuming a particular good). Likewise, microeconomic theory studies the behaviour of the individual firms in regard to the fixation of price and output and their reactions to the changes in the demand and supply conditions. From there we go on to establish price-output fixation by an industry (Industry means a group of firms producing the same product).
Thus, microeconomic theory seeks to determine the mechanism by which the different economic units attain the position of equilibrium, proceeding from the individual units to a narrowly defined group such as a single industry or a single market. Since microeconomic analysis concerns itself with narrowly defined groups such as an industry or market.
However it does not study the totality of behaviour of all units in the economy for any particular economic activity. In other words, the study of economic system or economy as a whole lies outside the domain of microeconomic analysis.
Microeconomic Theory Studies Resource Allocation, Product and Factor Pricing:
Microeconomic theory takes the total quantity of resources as given and seeks to explain how they are allocated to the production of particular goods. It is the allocation of resources that determines what goods shall be produced and how they shall be produced. The allocation of resources to the production of various goods in a free-market economy depends upon the prices of the various goods and the prices of the various factors of production.
Therefore, to explain how the allocation of resources is determined, microeconomics proceeds to analyse how the relative prices of goods and factors are determined. Thus the theory of product pricing and the theory of factor pricing (or the theory of distribution) falls within the domain of microeconomics.
The theory of product pricing explains how the relative prices of cotton cloth, food grains, jute, kerosene oil and thousands of other goods are determined. The theory of distribution explains how wages (price for the use of labour), rent (payment for the use of land), interest (price for the use of capital) and profits (the reward for the entrepreneur) are determined. Thus, the theory of product pricing and the theory of factor pricing are the two important branches of microeconomic theory.
Prices of the products depend upon the forces of demand and supply. The demand for goods depends upon the consumers’ behaviour pattern, and the supply of goods depends upon the conditions of production and cost and the behaviour pattern of the firms or entrepreneurs. Thus the demand and supply sides have to be analysed in order to explain the determination of prices of goods and factors. Thus the theory of demand and the theory of production are two subdivisions of the theory of pricing.
Microeconomics as a Study of Economic Efficiency:
Besides analysing the pricing of products and factors, and the allocation of resources based upon the price mechanism, microeconomics also seeks to explain whether the allocation of resources determined is efficient. Efficiency in the allocation of resources is attained when the resources are so allocated that maximises the satisfaction of the people.
Economic efficiency involves three efficiencies; efficiency in production, efficiency in distribution of goods among the people (This is also called efficiency in consumption) and allocative economic efficiency, that is, efficiency in the direction of production. Microeconomic theory shows under what conditions these efficiencies are achieved. Microeconomics also shows what factors cause departure from these efficiencies and result in the decline of social welfare from the maximum possible level.
Economic efficiency in production involves minimisation of cost for producing a given level of output or producing a maximum possible output of various goods from the given amount of outlay or cost incurred on productive resources. When such productive efficiency is attained, then it is no longer possible by any reallocation of the productive resources or factors among the production of various goods and services to increase the output of any good without a reduction in the output of some other good.
Efficiency in consumption consists of distributing the given amount of produced goods and services among millions of the people for consumption in such a way as to maximize the total satisfaction of the society. When such efficiency is achieved it is no longer possible by any redistribution of goods among the people to make some people better off without making some other ones worse off. Allocative economic efficiency or optimum direction of production consists of producing those goods which are most desired by the people, that is, when the direction of production is such that maximizes social welfare.
In other words, allocative economic efficiency implies that pattern of production (i.e., amounts of various goods and services produced) should correspond to the desired pattern of consumption of the people. Even if efficiencies in consumption and production of goods are present, it may be that the goods which are produced and distributed for consumption may not be those preferred by the people.
There may be some goods which are more preferred by the people but which have not been produced and vice versa. To sum up, allocative efficiency (optimum direction of production) is achieved when the resources are so allocated to the production of various goods that the maximum possible satisfaction of the people is obtained.
Once this is achieved, then by producing some goods more and others less by any rearrangement of the resources will mean loss of satisfaction or efficiency. The question of economic efficiency is the subject-matter of theoretical welfare economics which is an important branch of microeconomic theory.
That microeconomic theory is intimately concerned with the question of efficiency and welfare is better understood from the following remarks of A. P. Lerner, a noted American economist. “In microeconomics we are more concerned with the avoidance or elimination of waste, or with inefficiency arising from the fact that production is not organised in the most efficient possible manner.
Such inefficiency means that it is possible, by rearranging the different ways in which products are being produced and consumed, to get more of something that is scarce without giving up any part of any other scarce item, or to replace something by something else that is preferred. Microeconomic theory spells out the conditions of efficiency (i.e., for the elimination of all kinds of inefficiency) and suggests how they might be achieved. These conditions (called Pareto-optimal conditions) can be of the greatest help in raising the standard of living of the population.”
The four basic economic questions with which economists are concerned, namely:
(1) What goods shall be produced and in what quantities,
(2) How they shall be produced,
(3) How the goods and services produced shall be distributed, and
(4) Whether the production of goods and their distribution for consumption is efficient fall within the domain of microeconomics.
The whole content of microeconomic theory is presented in the following chart:
Microeconomics and the Economy as a whole:
It is generally understood that microeconomics does not concern itself with the economy as a whole and an impression is created that microeconomics differs from macroeconomics in that whereas the latter examines the economy as a whole; the former is not concerned with it. But this is not fully correct. That microeconomics is concerned with the economy as a whole is quite evident from its discussion of the problem of allocation of resources in the society and judging the efficiency of the same.
Both microeconomics and macroeconomics analyse the economy but with two different ways or approaches. Microeconomics examines the economy, so to say, microscopically, that is, it analyses the behaviour of individual economic units of the economy, their inter-relationships and equilibrium adjustment to each other which determine the allocation of resources in the society. This is known as general equilibrium analysis.
No doubt, microeconomic theory mainly makes particular or partial equilibrium analysis, that is, the analysis of the equilibrium of the individual economic units, taking other things remaining the same. But microeconomic theory, as stated above, also concerns itself with general equilibrium analysis of the economy wherein it is explained how all the economic units, various product markets, various factor markets, money and capital markets are interrelated and interdependent to each other and how through various adjustments and readjustments to the changes in them, they reach a general equilibrium, that is, equilibrium of each of them individually as well as collectively to each other.
Professor A. P. Lerner rightly points out, “Actually microeconomics is much more intimately concerned with the economy as a whole than is macroeconomics, and can even be said to examine the whole economy microscopically. We have seen how economic efficiency is obtained when the “cells” of the economic organism, the households and firms, have adjusted their behaviour to the prices of what they buy and sell. Each cell is then said to be in equilibrium.’ But these adjustments in turn affect the quantities supplied and demanded and therefore also their prices. This means that the adjusted cells then have to readjust themselves. This in turn upsets the adjustment of others again and so on. An important part of microeconomics is examining whether and how all the different cells get adjusted at the same time. This is called general equilibrium analysis in contrast with particular equilibrium or partial equilibrium analysis. General equilibrium analysis is the microscopic examination of the inter-relationships of parts within the economy as a whole. Overall economic efficiency is only a special aspect of this analysis.”
Importance and Uses of Microeconomics:
Microeconomics occupies a vital place in economics and it has both theoretical and practical importance. It is highly helpful in the formulation of economic policies that will promote the welfare of the masses. Until recently, especially before Keynesian Revolution, the body of economics consisted mainly of microeconomics. In spite of the popularity of macroeconomics these days, microeconomics retains its importance, theoretical as well as practical.
It is microeconomics that tells us how a free-market economy with its millions of consumers and producers works to decide about the allocation of productive resources among the thousands of goods and services. As Professor Watson says, “microeconomic theory explains the composition or allocation of total production, why more of some things are produced than of others.”
He further remarks that microeconomic theory “has many uses. The greatest of these is depth in understanding of how a free private enterprise economy operates.” Further, it tells us how the goods and services produced are distributed among the various people for consumption through price or market mechanism. It shows how the relative prices of various products and factors are determined, that is, why the price of cloth is what it is and why the wages of an engineer are what they are and so on.
Moreover, as described above, microeconomic theory explains the conditions of efficiency in consumption and production and highlights the factors which are responsible for the departure from the efficiency or economic optimum. On this basis, microeconomic theory suggests suitable policies to promote economic efficiency and welfare of the people.
Thus, not only does microeconomic theory describe the actual operation of the economy, it has also a normative role in that it suggests policies to eradicate “inefficiency” from the economic system so as to maximize the satisfaction or welfare of the society. The usefulness and importance of microeconomics has been nicely stated by Professor Lerner.
He writes, “Microeconomic theory facilitates the understanding of what would be a hopelessly complicated confusion of billions of facts by constructing simplified models of behaviour which are sufficiently similar to the actual phenomena to be of help in understanding them. These models at the same time enable the economists to explain the degree to which the actual phenomena depart from certain ideal constructions that would most completely achieve individual and social objectives.
They thus help not only to describe the actual economic situation but to suggest policies that would most successfully and most efficiently bring about desired results and to predict the outcomes of such policies and other events. Economics thus has descriptive, normative and predictive aspects.”
We have noted above that microeconomics reveals how a decentralised system of a free private enterprise economy functions without any central control. It also brings to light the fact that the functioning of a complete centrally directed economy with efficiency is impossible. Modern economy is so complex that a central planning authority will find it too difficult to get all the information required for the optimum allocation of resources and to give directions to thousands of production units with various peculiar problems of their own so as to ensure efficiency in the use of resources.
To quote Professor Lerner again, “Microeconomics teaches us that completely ‘direct’ running of the economy is impossible—that a modern economy is so complex that no central planning body can obtain all the information and give out all the directives necessary for its efficient operation.
These would have to include directives for adjusting to continual changes in the availabilities of millions of productive resources and intermediate products, in the known methods of producing everything everywhere, and in the quantities and qualities of the many items to be consumed or to be added to society’s productive equipment.
The vast task can be achieved, and in the past has been achieved, only by the development of a decentralised system whereby the millions of producers and consumers are induced to act in the general interest without the intervention of anybody at the centre with instructions as to what one should make and how and what one should consume.
Microeconomic theory shows that welfare optimum of economic efficiency is achieved when there prevails perfect competition in the product and factor markets. Perfect competition is said to exist when there are so many sellers and buyers in the market so that no individual seller or buyer is in a position to influence the price of a product or factor.
Departure from perfect competition leads to a lower level of welfare, that is, involves loss of economic efficiency. It is in this context that a large part of microeconomic theory is concerned with showing the nature of departures from perfect competition and therefore from welfare optimum (economic efficiency). The power of giant firms or a combination of firms over the output and price of a product constitutes the problem of monopoly.
Microeconomics shows how monopoly leads to misallocation of resources and therefore involves loss of economic efficiency or welfare. It also makes important and useful policy recommendations to regulate monopoly so as to attain economic efficiency or maximum welfare. Like monopoly, monopsony (that is, when a single large buyer or a combination of buyers exercises control over the price) also leads to the loss of welfare and therefore needs to be controlled.
Similarly, microeconomics brings out the welfare implications of oligopoly (or oligopsony) whose main characteristic is that individual sellers (or buyers) have to take into account, while deciding upon their course of action, how their rivals react to their moves regarding changes in price, product and advertising policy.
Another class of departure from welfare optimum is the problem of externalities. Externalities are said to exist when the production or consumption of a commodity affects other people than those who produce, sell or buy it. These externalities may be in the form of either external economies or external diseconomies. External economies prevail when the production or consumption of a commodity by an individual benefits other individuals and external diseconomies prevail when the production or consumption of a commodity by him harms other individuals.
Microeconomic theory reveals that when the externalities exist free working of the price mechanism fails to achieve economic efficiency, since it does not take into account the benefits or harms made to those external to the individual producers and the consumers. The existence of these externalities requires government intervention for correcting imperfections in the price mechanism in order to achieve maximum social welfare.
Several Practical Applications of Microeconomics for Formulating Economic Policies:
Microeconomic analysis is also usefully applied to the various applied branches of economics such as Public Finance, International Economics. It is the microeconomic analysis which is used to explain the factors which determine the distribution of the incidence or burden of a commodity tax between producers or sellers on the one hand and the consumers on the other.
Further, microeconomic analysis is applied to show the damage done to the social welfare or economic efficiency by the imposition of a tax. If it is assumed that resources are optimally allocated or maximum social welfare prevails before the imposition of a tax, it can be demonstrated by microeconomic analysis that what amount of the damage will be caused to the social welfare.
The imposition of a tax on a commodity (i.e., indirect tax) will lead to the loss of social welfare by causing deviation from the optimum allocation of resources the imposition of a direct tax (for example, income tax) will not disturb the optimum resource allocation and therefore will not result in loss of social welfare. Further, microeconomic analysis is applied to show the gain from international trade and to explain the factors which determine the distribution of this gain among the participant countries.
Besides, microeconomics finds application in the various problems of international economics. Whether devaluation will succeed in correcting the disequilibrium in the balance of payments depends upon the elasticity’s of demand and supply of exports and imports. Furthermore, the determination of the foreign exchange rate of a currency, if it is free to vary, depends upon the demand for and supply of that currency. We thus see that microeconomic analysis is a very useful and important branch of modern economic theory.