Macroeconomics studies national economies, and microeconomics studies the behavior of individual people and individual firms. Economists assume that people work toward maximizing their utility, or happiness, and firms act to maximize profits.
Eyeing the four basic market structures
An industry consists of all firms making similar or identical products. An industry’s market structure depends on the number of firms in the industry and how they compete. Here are the four basic market structures:
Perfect competition: Perfect competition happens when numerous small firms compete against each other. Firms in a competitive industry produce the socially optimal output level at the minimum possible cost per unit.
Monopoly: A monopoly is a firm that has no competitors in its industry. It reduces output to drive up prices and increase profits. By doing so, it produces less than the socially optimal output level and produces at higher costs than competitive firms.
Oligopoly: An oligopoly is an industry with only a few firms. If they collude, they reduce output and drive up profits the way a monopoly does. However, because of strong incentives to cheat on collusive agreements, oligopoly firms often end up competing against each other.
Monopolistic competition: In monopolistic competition, an industry contains many competing firms, each of which has a similar but at least slightly different product. Restaurants, for example, all serve food but of different types and in different locations. Production costs are above what could be achieved if all the firms sold identical products, but consumers benefit from the variety.
Finding market equilibrium price and quantity
Buyers and sellers interact in markets. Market equilibrium occurs when the desires of buyers and sellers align exactly so that neither group has reason to change its behavior. The market equilibrium price, p*, and equilibrium quantity, q*, are determined by where the demand curve of the buyers, D, crosses the supply curve of the sellers, S. At that price, the amount that the buyers demand equals the amount that the sellers offer.
In the absence of externalities (costs or benefits that fall on persons not directly involved in an activity), the market equilibrium quantity, q*, is also the socially optimal output level. For each unit from 0 up to q*, the demand curve is above the supply curve, meaning that people are willing to pay more to buy those units than they cost to produce. There are gains from producing and then consuming those units.
Identifying market failures
Sometimes markets fail to generate the socially optimal output level of goods and services. Several prerequisites must be fulfilled before perfect competition can work properly and generate that output level. Causes of market failure include the following:
Externalities caused by incomplete or nonexistent property rights: Without full and complete property rights, markets are unable to take all the costs of production into account.
Asymmetric information: If a buyer or seller has private information that gives her an edge when negotiating a deal, the opposite party may be too suspicious for both parties to reach a mutually agreeable price. The market may collapse, with no trades being made.
Public goods: Private firms can’t make money producing certain goods or services because there’s no way to exclude nonpayers from receiving them. The government or philanthropists usually have to provide such goods or services.
Monopoly power: Monopoly power is the ability to raise prices and restrict output in order to increase profits. Both monopolies (firms that are the only sellers in their industries) and collusive oligopolies (industries with only a few firms that coordinate their activities) can possess monopoly power. Monopolies and collusive oligopolies produce less than the socially optimal output level and produce at higher costs than competitive firms.
Linking macroeconomics and government policy
Macroeconomics studies national economies, concentrating on economic growth and how to prevent and ameliorate recessions. Governments fight recessions and encourage growth using monetary policy and fiscal policy.
Economists use gross domestic product (GDP) to keep track of how an economy is doing. GDP measures the value of all final goods and services produced in an economy in a given period of time, usually a quarter or a year.
A recession occurs when the overall level of economic activity in an economy is decreasing, and an expansion occurs when the overall level is increasing.
The unemployment rate, which measures what fraction of the labor force consists of those without jobs who are actively seeking jobs, normally rises during recessions and falls during expansions.
Anti-recessionary economic policies come in two flavors:
Expansionary monetary policy: The government can increase the money supply to lower interest rates. Lower interest rates make loans for cars, homes, and investment goods cheaper, which means increased consumption spending by households and increased investment spending by businesses.
Expansionary fiscal policy: Increasing government purchases of goods and services or decreasing taxes can stimulate the economy. Increasing purchases increases economic activity directly, giving businesses money to hire new workers or pay for increased orders from their suppliers. Decreasing taxes increases economic activity indirectly by leaving households with more after-tax dollars to spend.