Microeconomics For Dummies
Overview
Find easy-to-follow coverage of microeconomics basics.
Microeconomics For Dummies, 2nd U.S. Edition demystifies the complex world of microeconomics, offering down-to-earth explanations and real-world applications that make microeconomics make sense to everyone. This guide tackles a question that drives much of the world around us: how do people and firms make economic decisions every day?
This useful resource transforms intimidating economic theory into understandable, practical knowledge—covering everything from consumer behavior and company decision-making to market structures and welfare economics.
You’ll find:
- Understand consumer theory, inputs and outputs, welfare economics as a whole and more
- Coverage of making economic choices under uncertainty, with info explaining decision-making in unpredictable situations
- A look into trade and comparative advantages, showing how microeconomics drives global commerce
Perfect for college students taking microeconomics courses looking for a reliable study companion, business professionals trying to better understand market dynamics, and everyday people who just want to understand the world a little better, Microeconomics For Dummies will help you understand why prices change, markets fluctuate, and businesses behave the way they do.
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About The Author
Lynne Pepall, PhD, is Professor Emerita at Tufts University, where she served as Dean of the Graduate School. Her research in industrial organization appears in major economics journals. She’s a co-author of Industrial Organization: Contemporary Theory and Empirical Applications.
Manzur Rashid, PhD has taught economics at UCL, Cambridge University, New College of the Humanities, and Charterhouse.
Peter Antonioni teaches in the Department of Management Science and Innovation at University College London.
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In this list are some great economists who inspired us to discover microeconomics. What follows is a — perhaps slightly eccentric — list of inspiring and challenging thinkers. But they're just the tip of a huge iceberg.
Alfred Marshall (1842–1924)
The approach to microeconomics that is the mainstream approach for the profession is sometimes called marginalism, and much of it is due to Alfred Marshall.
Economics
When discussing a firm, economists generally assume that the firm wants to maximize profits — in other words, that the difference between total revenue and total costs is positive and as large as possible. Economists don't think there's anything immoral about profit maximization. Rather, they believe that profit maximization is a goal that helps a firm be efficient, and firms that don't make profits tend not to operate as firms for very long.
Economics
A firm with a given technology makes a choice about how much of each of the factors of production to use to make how much output — and pays the cost for doing so. The question for the firm is how to use its technology and choose its inputs in order to make its profits as large as possible.
The way it does so is to choose its inputs in order to make the costs as small as possible.
Economics
Economists begin with a model that has rational agents — in the sense that they are logically consistent in their behavior — and they make the fewest assumptions about the tastes or preferences of these agents. Because economists don't know very much about the people they're modeling — there are 7 billion people on Earth, after all — starting with what you think is common to them all makes sense.
Economics
A criticism sometimes leveled at the economists' view of a representative "person" is that such a construction could describe a psychopath, in the sense that representative consumers follow their own interests and make a rational choice between options that allows them to maximize their own utility.
Microeconomists aren't psychiatrists and so can't give a medical view on whether this description satisfies the conditions for diagnosing a psychopath, but there are a couple of flaws in this view of what economists think of as a representative agent:
This criticism is rooted in a framing problem.
Economics
One way to think about consumption bundles and preferences on microeconomics is to think about all the possible choices. If you describe the set of possible choices in a diagram, you can see pretty easily which choices the consumer would prefer.
For instance, this figure draws an indifference curve for all the consumption bundles for which Bob gets the same amount of utility.
Economists distinguish between the long- and short-run positions of a firm. They do so because a firm can find itself, in the short run, in a number of positions where it is constrained.
It can't fully react to change immediately and therefore makes slightly different decisions than it would if there were no constraints — in other words, different than it would in the long run if it were fully capable of reacting to whatever change (pricing, technological, demand, and so on) was taking place.
Economics
Many economic activities require rather more than simply buying something and selling it on. These stages of creating the product involve more complex forms of organization than that of the sole trader.
Consider, for example, the set of production processes involved in making computers: dealing with contractors; managing international product development; creating the complementary products (software and operating systems); and managing the people and processes involved.
Economists are often accused of treating firms too simply. By disregarding differences in organizational behavior, technology, or place, and by treating firms more simply as a kind of black box that takes inputs in and creates outputs from them, are economists painting a misleading picture that makes firms interchangeable and ignores important differences between them?
Economics
One thing you can say about the relationship between preferences and the budget constraint is about the principle of revealed preference. Utility isn't measured, but things about utility can be found out by observing consumer choices and inferring from their choices the impact of price changes on their utility or welfare.
Suppose that you want to compare bundles that are on different levels of utility. Easy! You draw a set of indifference curves moving away from the origin. Each individual curve has the same level of utility along the curves, and each curve expresses a higher level of utility the further away from the origin it is!
Economics
A budget constraint maps the relative availability of two goods to a fixed amount of resources, called M. In the consumer choice model, this means that you take account of an increase in income by moving the budget constraint away from the origin so that the new curve is parallel to the old, as shown here.
Representing a change in income by shifting the budget constraint.
Economics
Changing income shifts your budget constraint up or down, or if all the prices of the goods you're interested in change at the same rate, your budget constraint shifts up or down in a similar fashion.
But suppose that some prices change more than others. It's more likely that some prices go up and others stay the same rather than all prices changing by the same percentage.
Economics
In a two-good model, the budget line is a simple straight line whose slope is the ratio of prices. But if, for instance, a tax changes the cost of a good relative to others, that is tantamount to a price change, and you can use the shape of the budget line to think about how to analyze the effect of the tax.
Before doing so, you have to be a bit more specific about the type of tax, because different taxes do different things to the shape of the budget line.
Economics
Economists don't take the nature of changing inputs into outputs for granted. Since Adam Smith, economists have been describing in various ways the methods a firm can use to transform inputs into outputs, which they call technologies.
A technology is a description of the way a firm transforms inputs into outputs.
Economics
When investigating the effect of a price change, a good place to start is by thinking about what the change will do to the behavior of a representative consumer. Indifference curves excel in this situation!
Start at a given equilibrium to get a sense of what is happening before you make changes. In this case, the plot shown is an equilibrium with well-behaved indifference curves and a standard budget constraint, and at the consumer optimum, the price ratio equals the marginal rate of substitution between goods x1 and x2.
Total utility (the amount of utility gained in total from consuming something) is a useful concept, but economists far more commonly look at how utility changes as consumption at the margin changes. For that, they use the concept of marginal utility: the utility that is gained from consuming one extra unit of a good.
Economics
Markets are places, real or virtual, where consumers and producers come together to trade. In theory, the trades make both sides better off, though not necessarily to the same extent.
Markets coordinate people's desire for "stuff" with producers' ability to make "stuff," but importantly with no one being in charge of the process.
Economics
Economists look at decisions in a slightly different way from how you might expect. They don't have a model of all the things that you as a consumer would use to inform your decisions.
They don't know, for example, who you are, or more precisely what all your values are. They make no assumptions about gender, ethnicity, sexuality, or anything else.
The key to moving from unconstrained optimization to constrained optimization is the introduction of a budget constraint. This is a method of conceptualizing all the ways that the choice of doing or buying something is held back by the availability of resources, whether in terms of money, time, or something else.
Economics
One word that's central to microeconomics is decision. Microeconomics is ultimately about making decisions: whether to buy a house, how much ice cream to make, what price to sell a bicycle at, or whether to offer a product to this or that market, and so on.
This is one reason why economists center their models on choice.
Economics
The situation of many companies following their own interests leads to competition. In almost all circumstances, competition is a pretty good thing, because it can lead to lower costs or more innovation.
For example, if only one store operates in your area, it may be able to get away with selling milk for $5 a gallon.
One of the key insights into how a market economy organizes production is the concept in microeconomics of a firm: an entity or agent that produces things.
The best approach to start thinking about the firm is in a simple way, by considering the smallest possible unit of production: a single-person-operated firm such as a market stall (in the U.
There are many views about why people choose what they do, with psychologists and sociologists approaching the question in their own ways. In turn, microeconomists focus on one explanation for people making a given choice over another one: that the choice delivers more utility.
The idea of utility
Utility is a tricky term to pin down in concrete terms (see the nearby sidebar "The complex history of utility" for a discussion of the philosophical issues involved).
Economics
Productive efficiency is satisfied when a firm can't possibly produce another unit of output without increasing proportionately more the quantity of inputs needed to produce that unit of output. It's met when the firm is producing at the minimum of the average cost curve, where marginal cost (MC) equals average total cost (ATC).
Following are some of the conditions that determine which markets are oh so perfect and which fall below the standard. A number of factors are required for a given market to be in perfect competition:
Each firm is small relative to the market and has no influence on price.
Firms and products are substitutable.
Microeconomics is fundamentally about what happens when individuals and companies make decisions. The idea is to understand how those decisions are made and explore their consequences.
What happens, for example, when prices of houses go up? Well, on the one hand, people are likely to buy fewer or smaller houses.
The important difference between the model of an oligopoly and the model of a perfectly competitive market is that firms in oligopoly can influence market outcomes. As a result, firms behave strategically and try to anticipate the strategic interactions among each other. This means that they form beliefs about what their rivals might do in response to their acts.
Economics
By itself, total cost doesn't say much about the firm and still less about how it makes its decisions. Economists want to discover a little more about how the firm operates, so they look at the relationship between total cost and the number of units produced. To do so, they divide the cost of production by the number of units produced to derive the average costs.
Economics
The breakdowns used for average costs and total costs show costs for a particular level of production. But economists also use another important measure to consider when considering a firm's costs: marginal cost.
Meeting marginal cost
Put simply, marginal cost (MC) is the cost of adding one extra unit of output to your current output level.
Economics
The most global view of a company is in terms of its total costs (TC), which economists use quite simply to arrive at a number for total profits (you don't need to worry about gross or net terms here). Total costs are simply the overall cost of making a product and serving it to a market after all those relevant cost elements are accounted for.
Put simply, the Slutsky equation says that the total change in demand is composed of an income and a substitution effect and that the two effects together must equal the total change in demand:
This equation is useful for describing how changes in demand are indicative of different types of good. Indifference curves are always downward sloping, and so the substitution effect must always turn out to be negative.
Economics
Firms in perfectly competitive markets are price takers. To understand the competitive position among the firms in a competitive market, it is helpful to look at the supply decisions an individual firm will make. This means that if you want to see what's happening in the market, you have to return to looking at the firm's cost curves.
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.
The budget constraint divides what is feasible from what is not feasible. You can use the model of consumer choice and take a look at what a consumer will do to optimize her utility or satisfaction when a constraint exists. To do this, you have to take a look at what happens when you put the indifference curves together with the budget constraint.
Allocative efficiency is related to the concept of Pareto efficiency that economists use to look at social welfare, but it has important aspects that are driven by efficiency in production. Essentially, if something is allocatively efficient, one party can't possibly be made better off without making another party worse off.
Economics
If you've ever been unable to consume a tenth bar of chocolate, you've experienced the phenomenon of diminishing marginal utility, meaning that as you consume increasing amounts of the same thing, the utility gained from each additional amount is smaller, as you add more and more.
At some point, the marginal utility can fall to zero and you desire no more of the good — it can even turn negative afterwards (yes, it's true, you can eat so much chocolate that eating any more causes displeasure rather than pleasure).
Perfect competition is the name economists give to a market with many interchangeable firms, none of which can independently influence the market outcome. This scenario isn't all that likely in the real world, because it depends on a set of conditions that are unlikely to hold. But some markets do get quite close to approximating perfect competition; of course, many others do not come close.
Economics
A consumption bundle is a set of goods that a consumer may choose to consume. Suppose the only goods available in the world are tea and coffee. Then a consumption bundle is any combination of cups of tea and coffee that the person could choose, and you can write
(tea, coffee)
For the bundle containing one cup of tea and one cup of coffee, the bundle would be written as
(1 tea, 1 coffee)
Now imagine that the items in the brackets can represent any goods whatsoever.
Economics
Economists look at costs in a particular way, which may not be what you expect. Every firm in every industry in every country incurs costs of one kind or another, and accounting systems provide a way of measuring and recording them.
But economists are interested in more than the record of what was done in the past.
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