Microeconomics For Dummies
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Microeconomics is a huge area of study, but following are many of the most important core ideas of microeconomics. Remember these ten tips as you continue your study in microeconomics.

Respecting choice

All microeconomics is built on the idea that consumers and producers make choices about what to make or what to buy. As a result, economists tend to have a healthy respect for choice itself. People value things in different ways, and economists want to look at the consequences of, rather than the reasons for, those values.

You only get to know what value people place on something after they choose it — or as economists say, you get to know people's preferences when they have chosen (they also say that there are as many valuations as people).

Trade is possible because people value things differently. The desire to trade creates the need for a means to trade things — a market.

Pricing a good: difficult but not impossible

In several situations, a market has difficulty pricing a good. One case is when the marginal cost of the good is at or near zero — a competitive market ends up with no one being able to price above zero and everyone scrambling around for other ways to make money. Public goods — such as street lighting, public parks, or even law enforcement — are another case, one made worse by the impossibility of excluding people who haven't paid for these services from using them.

But just because a market finding a competitively sustainable solution is difficult, that doesn't mean it's impossible.

People are essentially creative in such situations. When they come up against an unfavorable economic situation, they try to find solutions to get around the problem. Economists have great respect for this creativity, which is one reason why they want to see what can be achieved without intervening, before coming up with ways to intervene.

Competing on price or quality

In a perfectly competitive market, competition is only ever on price, which is always forced down to the marginal cost of production for the marginal firm. But in many market structures, competing on price is tough, and firms have an incentive to focus on other dimensions of their product.

If you start in monopolistic competition — which is a common market structure — you can see why. If you compete on price, over the long run, the price gets pushed down to average cost, and the firm doesn't make profits. The alternative is to change your focus and try to make your product different or distinctive from the other competitors and, in so doing, make nonzero profits. However, you need to invest to do that, and if you're investing in keeping the product different or better, you're using resources that you could've spent on getting costs down.

This problem is one reason why firms tend to choose either to be the lowest-cost competitor or a high-quality competitor. The alternative is generally pleasing neither to people who want things cheap nor to those who want good quality.

Seeking real markets' unique features

Markets do have unique and distinctive features — such as, for example, in health care — that often vary from place to place and product to product.

When economists come across distinctive features, they explore the differences between that market and a more generic one. Sometimes they propose ways to make such markets more productive or efficient. Most importantly, economists look very carefully at why a particular market exhibits those features before they rush in and call it a market failure. Instead, they ask a number of questions: Is the market like that because people value things in a particular way? Is a distortion involved, such as a tax or a subsidy? Are there very high sunk costs?

Generic models form a starting point for comparison. Economists aren't trying to say a given market should be exactly like this or that.

Beating the market in the long run is very difficult

The phrase you can't beat the market is the kind of saying that drives economists to distraction. For a start, when transaction costs are high, a market in many cases is not the most efficient organizational design. Plus, it's just not realistic to suggest, for instance, that all firms should abandon management structures and replace them with internal markets.

When economists say that you can't beat the market, they're pointing out that they know that markets can be shown to achieve the highest level of efficiency.

Always be skeptical of people's claims that they can make long-run profits — and therefore, if you're an investor, returns — greater than the average of those in the market they're in. Why? Well, if they could, someone would come in and compete them away. Watch your wallet when anyone claims to be able to beat the market in the long run.

Knowing a tradeoff always exists somewhere

The economist's model of consumer behavior is called a constrained optimization — because ultimately you're trying to do your best given that you can't have everything. As a result, at some point you have to choose between one option and another because you can't have both.

As long as things are scarce, you have to make choices. To an economist, this is just a fact of life, and you may as well complain about gravity as about scarcity. That means that getting your best level of utility is always about trading off one thing for another.

A good rule for looking at the world is that if you see a free lunch, ask who's paying for it: If you're not, someone else probably is. When a product seems free — as it does for some Internet services, especially in social media, check whether the product is actually you — or more accurately, your personal information that has a value to whoever is offering the service "free."

Arguing about the next best thing

As Mick Jagger sang, you can't always get what you want. Microeconomics has some advice for you though. An economic principle, the Theory of the Second Best, reminds you that if you can't get the optimal solution, then there may be second-best alternatives.

Although getting the optimal isn't possible, you can certainly argue about what the next best thing is. Economists recommend that you look carefully at the inefficiency and the external cost in this situation before coming up with a solution.

When you hear politicians arguing about what to do, remember that often the argument isn't about what the best thing is, but which of several "practical" options is the second best. You can then choose, on the basis of your investigations, and sometimes on which party you want to support.

Using markets isn't always costless

Even though economists generally prefer free exchange — and therefore markets — as their way of achieving goals, using those markets isn't always costless. Sometimes, an unaccounted cost falls upon another person — an external cost — and sometimes there are costs associated with just finding the person to trade with — transactions costs.

To an economist, the key question is what makes those costs as low as possible? The answer isn't as simple as just saying that a market inevitably keeps those costs at the lowest possible level.

Economists have two pieces of advice here:

  • Think carefully about where the inevitable costs of using a market fall.

  • Seek out the opportunities that always exist for entrepreneurs with good ideas for reducing transactions costs for buyers and sellers.

Believing that competition is good — usually

Any time a market isn't perfectly competitive, the firms in the industry are getting a greater share of the gains from trade. As a result, they always have an interest in preventing another firm from coming in and competing away the gains. They may erect barriers to do so — including advertising, investing in things that involve sunk costs, and making their product or brand different or unique in the consumer's eye.

These tactics can prevent a rival, even one producing at a lower cost, from competing and taking away some market share. Consumers lose out because the incumbent producers produce less, for higher cost, and take more of the surplus. For this reason, economists look carefully at barriers to market entry and work to get them down as low as possible in the long run.

But that isn't the whole story. There are times when economists give two cheers to markets that aren't competitive. For example, a monopolist doesn't compete with itself, which can mean that you can get a better range of product diversity when there is less competition.

Getting cooperation and organization in the world

Economics often gets a bad rap because the assumed behavior of individuals in economics seems selfish, because the model of people and firms seems to make a priority of individual benefit, and even because the model of an individual making decisions doesn't try to reproduce many of the features people think of as essential. But in fact economists are the world's greatest optimists.

Why? Well, economic models are built from no greater assumption than that people follow their own interests — and in so doing, create firms, organizations, production, and consumption, and all the things that make the world go round!

About This Article

This article is from the book:

About the book authors:

Lynne Pepall, PhD, is a professor of economics at Tufts University. She has taught microeconomics at both graduate and undergraduate levels since 1987.

Peter Antonioni is a senior teaching fellow at the Department of Management Science and Innovation, University College, London, and coauthor of Economics For Dummies, 2nd UK Edition.

Manzur Rashid, PhD, is a lecturer at New College of the Humanities, where he covers second-year micro- and macroeconomics.

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