One of the goals of microeconomics is to analyze market mechanisms that establish relative prices amongst goods and services and allocation of limited resources amongst many alternative uses. Microeconomics analyzes market failure, where markets fail to produce efficient results, as well as describing the theoretical conditions needed for perfect competition. Significant fields of study in microeconomics include markets under asymmetric information, choice under uncertainty and economic applications of game theory.
- 1 Assumptions and definitions
- 2 Modes of Operation
- 3 Opportunity cost
- 4 Taxonomy of Microeconomics
- 5 External links
Assumptions and definitions
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 or groups of buyers or sellers do have the ability to influence prices. Quite often a sophisticated analysis is required to understand the demand-supply equation of a good. However, the theory works well in simple situations.
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 so-called market failures lead to resource allocation that is suboptimal by some standard (highways are the classic example, profitable to all for use but not directly profitable for anyone to finance). In such cases, economists may attempt to find policies that will avoid waste; 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.
The demand for various commodities by individuals is generally thought of as the outcome of a utility-maximizing process. The interpretation of this relationship between price and quantity demanded of a given good is that, given all the other goods and constraints, this set of choices is that one which makes the consumer happiest.
Modes of Operation
It is assumed that all firms are following rational decision-making, and will produce at the profit-maximizing output. Given this assumption, there are four categories in which a firm's profit may be considered.
A firm is said to be making an economic profit when its average total cost is less than the price of the product at the profit-maximizing output. The economic profit is equal to the quantity output multiplied by the difference between the average total cost and the price.
A firm is said to be making a normal profit when its economic profit equals zero. This occurs where average total cost equals price at the profit-maximizing output.
If the price is between average total cost and average variable cost at the profit-maximizing output, then the firm is said to be in a loss-minimizing condition. The firm should still continue to produce, however, since its loss would be larger if it were to stop producing. By continuing production, the firm can offset its variable cost and at least part of its fixed cost, but by stopping completely it would lose the equivalent of its entire fixed cost.
If the price is below average variable cost at the profit-maximizing output, the firm is said to be in shutdown. Losses are minimized by not producing at all, since any production would not generate returns significant enough to offset any fixed cost and part of the variable cost. By not producing, the firm loses only its fixed cost.
In economics, a market failure is a situation in which markets do not efficiently organize production or allocate goods and services to consumers (for example, a failure to allocate goods in a way some see as socially or morally preferable). To economists, the term would normally be applied to situations where the inefficiency is particularly dramatic, or when it is suggested that non-market institutions would provide a more desirable result. On the other hand, to many, market failures are situations where market forces do not serve the perceived "public interest". Here, the focus is on the economists' theories of market failure.
Economists use model-like theorems to explain or understand such cases. The two main reasons that markets fail to produce efficient results are:
- the inadequate expression of costs or benefits in prices and thus into microeconomic decision-making in markets.
- sub-optimal market structures
In economics, information asymmetry occurs when one party to a transaction has more or better information than the other party. (It has also been called asymmetrical information and markets with asymmetrical information). Typically it is the seller that knows more about the product than the buyer, but this is not always the case.
Examples of situations where the seller usually has better information than the buyer are numerous and include used-car salespeople, stockbrokers, real estate agents, and life insurance transactions.
Examples of situations where the buyer usually has better information than the seller include estate sales as specified in a last will and testament.
This situation was first described by Kenneth J. Arrow in a seminal article on health care in 1963 entitled "Uncertainty and the Welfare Economics of Medical Care," in the American Economic Review.
George Akerlof later used the term asymmetric information in his 1970 work The Market for Lemons. He also noticed that, in such a market, the average value of the commodity tends to go down, even for those of perfectly good quality. It is even possible for the market to decay to the point of nonexistence.
Because of information asymmetry, unscrupulous sellers can "spoof" items (like software or computer games) and defraud the buyer. As a result, many people not willing to risk getting ripped off will avoid certain types of purchases, or will not spend as much on a given item.
Main article: Opportunity cost
Although opportunity cost can be hard to quantify, the effect of opportunity cost is universal and very real on the individual level. In fact, this principle applies to all decisions, not just economic ones. Since the work of the Austrian economist Friedrich von Wieser, opportunity cost has been seen as the foundation of the marginal theory of value.
Opportunity cost is one way to measure the cost of something. Rather than merely identifying and adding the costs of a project, one may also indentify the next best alternative way to spend the same amount of money. The forgone profit of this next best alternative is the opportunity cost of the original choice. A common example is a farmer that chooses to farm his land rather than rent it to neighbors, wherein the opportunity cost is the forgone profit from renting. In this case, the farmer may expect to generate more profit himself. Similarily, the opportunity cost of attending university is the lost wages a student could have earned in the workforce, rather than the cost of tuition, books, and other requisite items (whose sum makes up the total cost of attendance). The opportunity cost of a vacation in the Bahamas might be the down payment money for a house.
Note that opportunity cost is not the sum of the available alternatives, but rather the benefit of the single, best alternative. The opportunity cost of the city's decision to build the hospital on its vacant land is the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money that could have been made from selling the land, or the loss of any of the various other possible uses -- but not all of these in aggregate. The true opportunity cost would be the forgone profit of the most lucrative of those listed.
One question that arises here is how to assess the benefit of dissimilar alternatives. We must determine a dollar value associated with each alternative to facilitate comparison and assess opportunity cost, which may be more or less difficult depending on the things we are trying to compare. For example, many decisions involve environmental impacts whose dollar value is difficult to assess because of scientific uncertainty. Valuing a human life or the economic impact of an Arctic oil spill involves making subjective choices with ethical implications.
Taxonomy of Microeconomics
Fundamental concepts in microeconomics
Elasticity - Consumer surplus - Producer surplus - Aggregation of individual demand to total, or market, demand
Preference - Indifference curve - Utility - Marginal utility - Income
Production and pricing theory
Production theory basics - X-efficiency - Factors of production - Production possibility frontier - Production function - Economies of scale - Economies of scope - Profit maximization - Price discrimination - Transfer pricing - Joint product pricing - Price points
Welfare economics - Pareto efficiency - Kaldor-Hicks efficiency - Edgeworth box - Social welfare function - Income inequality metrics - Lorenz curve - Gini coefficient - Poverty level - Dead weight loss
Market form - Perfect competition - Monopoly - Monopolistic competition - Oligopoly - Concentration ratio - Herfindahl index
- Collective action - Information asymmetry - Externality - Social cost - Free goods - Taxes - Tragedy of the commons - Tragedy of the anticommons - Coase's Penguin.
Efficient markets theory - Financial economics - Finance - Risk
International trade - Terms of trade - Tariff - List of international trade topics
General equilibrium - Game theory - Institutional economics - Neoclassical economics - Austrian economics
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